SOLUTIONS MANUAL For Financial Accounting Theory Seventh Edition William R. Scott. by StudyGuide

Contents

Chapter 1

Introduction.................................................................................................. 1

Chapter 2

Accounting Under Ideal Conditions .......................................................... 7

Chapter 3

The Decision Usefulness Approach to Financial Reporting...................... 68

Chapter 4

Efficient Securities Markets ...................................................................... 129

Chapter 5

The Value Relevance of Accounting Information ..................................... 153

Chapter 6

The Measurement Approach to Decision Usefulness ................................ 194

Chapter 7

Measurement Applications ........................................................................ 237

Chapter 8

The Efficient Contracting Approach to Decision Usefulness.................... 285

Chapter 9

An Analysis of Conflict ...........................................................................321

Chapter 10 Executive Compensation .........................................................................371 Chapter 11 Earnings Management .............................................................................425 Chapter 12 Standard Setting: Economic Issues ..........................................................487 Chapter 13 Standard Setting: Political Issues.............................................................527

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CHAPTER 1 INTRODUCTION 1.1

The Objective of This Book

1.2

Some Historical Perspective

1.3

The 2007-2008 Market Meltdowns

1.4

Efficient Contracting

1.5

A Note on Ethical Behaviour

1.6

Rules-Based v. Principles-Based Accounting Standards

1.7

The Complexity of Information in Financial Accounting and Reporting

1.8

The Role of Accounting Research

1.9

The Importance of Information Asymmetry

1.10

The Fundamental Problem of Financial Accounting Theory

1.11

Regulation as a Reaction to the Fundamental Problem

1.12

The Organization of This Book 1.12.1 Ideal Conditions 1.12.2 Adverse Selection 1.12.3 Moral Hazard 1.12.4 Standard Setting 1.12.5 The Process of Standard Setting

1.13

Relevance of Financial Accounting Theory to Accounting Practice

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LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

The Broad Outline of the Book

I use Figure 1.1 as a template to describe the broad outline of the book. Since the students typically have not had a chance to read Chapter 1 in the first course session, I stick fairly closely to the chapter material. The major points I discuss are: •

Accounting in an ideal setting. Here, present-value-based accounting is natural. I go over the ideal conditions needed for such a basis of accounting to be feasible, but do not go into much detail because this topic is covered in greater depth in Chapter 2.

•

An introduction to the concept of information asymmetry and resulting problems of adverse selection and moral hazard. These problems are basic to the book and I feel it is desirable for the students to have a “first go” at them at this point. I concentrate on the intuition underlying the two problems. For example, adverse selection can be illustrated by asking who would be first in line to purchase life insurance if there was no medical examination, or what quality of used cars are likely to be brought to market. For moral hazard I try to pin them down on how hard they would work in this course if there were no exams.

•

The environment in which financial accounting and reporting operates. My main goal at this point is that the students do not take this environment for granted. I discuss the procedures of standard setting briefly and point out that this is really a process of regulation. In the past, there have been well-known cases of deregulation, such as airlines, trucking, financial institutions, power generation. However, we are entering what is likely to be a period of increasing regulation, at least for financial institutions. Instructors 2 .

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may wish to discuss briefly the pros and cons of markets v. regulation (since this book tends to be market-oriented) of economic activity. 2.

The Concept of Information

By now, I will have referred to the term “information” several times. I suggest that it is easy to take this term for granted, and call for definitions. This usually generates considerable hesitation by the students. The purpose at this point is simply to get them to realize that information is a complex commodity. Indeed, I make an analogy between the financial accounting and reporting industry and a stereotypical manufacturing industry such as agriculture or automobiles, and ask what is the product of the accounting industry, why is it valuable, how is it quantified? I do not go deeply into the answers to questions like these, since some decision-theoretic machinery needs to be developed (Section 3.3) before a precise definition of information can be given. Nevertheless, I try to end up with the conclusions that information has something to do with improving the process of decision-making, and that it is crucial to the operation of securities markets. 3.

Relevance to Accounting Practice

My undergraduate accounting theory classes usually consist of a majority of students who are heading for a professional accounting designation. There are usually also some students heading for careers in management. Since students who are facing professional accounting exams can be quite focused in their learning objectives, it is essential that the nature of the course in relation to these objectives be discussed up front. I begin by pointing out that the book is intended to give the student an appreciation and understanding of the financial reporting environment, which should help with breadth questions on professional exams. I also argue that one’s career continues well beyond attainment of a professional accounting designation, and that the nature of the textbook is longer-run and designed to 3 .

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foster a critical awareness of the financial accounting environment which is needed if one is to become a thoughtful professional. Arguments such as these can only be pushed so far. Nevertheless, I think it is important to make them. I also point out that the text includes coverage of major accounting standards such as financial instruments, impairment, consolidations, de-recognition, and that they will have the opportunity to learn about these standards on the way through. I also refer the students to Section 1.13, and emphasize that the text recognizes an obligation to convince them that the material is relevant to their careers. To do this, the text explains theoretical concepts in intuitive terms, and illustrates and motivates the concepts based on a series of Theory in Practice vignettes, and problem material based frequently on articles from the financial press and relevant research findings. For the management students in the class, and for the professional accounting students who may some day be managers, I emphasize that the text does not ignore them. Chapters 8 to 11 inclusive (the bottom branch of Figure 1.1) deal with topics of interest to managers, including economic consequences, conflict resolution, executive compensation and earnings management. All of these topics demonstrate that management has a legitimate interest in financial reporting. I also argue that Chapters 2 to 7 inclusive (the top branch of Figure 1.1) are relevant to managers since they give insights into how financial accounting information is used by investors. Finally, since management is a major constituency in standard-setting, a critical awareness of the need for standard setting and the standard-setting process (Chapters 12 and 13) is useful for any manager. I have not had problems with student course evaluations as a result of using the material in this book. In fact, I have constantly been surprised at how far one can push the students in a theoretical direction providing that I rely on the textbook material to give the students an intuitive understanding, and concentrate in class 4 .

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on illustrating, motivating and discussing the application of the concepts. For this, I find that the financial media are helpful sources of current articles which I bring to class to serve as a basis for discussion. Numerous such articles form the basis of most “Theory in Practice” vignettes scattered throughout the text. 4.

The Structure of Standard-Setting Bodies

This edition continues to orient itself to International Accounting Standards Board (IASB) standards, although attention is also given to several U.S. standards. Instructors may wish to briefly discuss the structure of standard setting bodies at this point. 5.

Social Issues Underlying Regulation

Instructors who wish to dig more deeply into social issues underlying financial reporting and standard setting can usefully spend a class session on the 1982 Merino and Neimark paper (in Section 1.2). This paper raises fundamental issues about the role of financial reporting in society which go well beyond the textbook coverage of this paper, which confines itself largely to a brief description of reporting problems leading up to the great stock market crash of 1929 and the creation of the SEC. It provides food for thought both for those who do and do not favour the present financial reporting environment. For a contrasting view from that of Merino and Neimark, Benston’s 1973 article is also worth assigning. This edition continues its discussion of the Enron and WorldCom financial reporting disasters, since these are still relevant to accounting theory and practice. I continue to include (Section 1.3) a description of the 2007-2008 market meltdowns surrounding financial assets and institutions, since these events are driving many new accounting standards and changes in executive compensation discussed later in the text. In spite of the bewildering collection of acronyms, instructors may wish to discuss these market meltdowns early in the course, since they pervade the book and continue to have major implications for financial accounting. 5 .

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Section 1.5 introduces the topic of ethics. With the extent of accountant and auditor involvement in numerous financial reporting disasters that have come to light since 2000, such as Enron and WorldCom, and more recent criticisms of fair value accounting and off-balance sheet entities, the importance of ethical behaviour is very much apparent. Indeed, ethical behaviour underlies the distinction between rules-based and principles-based accounting standards (Section 1.6). This distinction is important since the IASB constitution commits the IASB to principles-based standards. I emphasize, however, that ethics tends to produce similar behaviour as a longerrun maximization of one’s own interests (although the mind sets are different). Thus, a longer–run view of ethical behaviour quickly turns into questions of full disclosure, usefulness, reputation, and cooperative behaviour. The text tends to emphasize these latter components of professional responsibility. Some instructors may wish to introduce and discuss ethical issues more broadly. 6.

Some influential accounting academics are critical of the moves by

standard setting bodies towards current value accounting. Chapter 8 is devoted to an alternative view, namely efficient contract theory (also called positive accounting theory). A brief introduction to this topic is given in Section 1.4. Instructors who wish to introduce this topic now may wish to discuss why accountants are generally regarded as conservative, whether financial accounting can help to attain strong corporate governance, and whether managers like current value accounting. 7.

I have not prepared any questions and problems for this chapter. One

reason is that I usually like to let the first week of classes pass before giving formal assignments. More fundamentally, I use this first week to describe and motivate the text material, as outlined above, and most of the material in Chapter 1 is covered in greater detail later. However, extensive problem material is provided for the remaining chapters of the book.

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CHAPTER 2 ACCOUNTING UNDER IDEAL CONDITIONS 2.1

Overview

2.2

The Present Value Model Under Certainty 2.2.1 Summary

2.3

The Present Value Model Under Uncertainty 2.3.1 Summary

2.4

Examples of Present Value Accounting 2.4.1 Embedded Value 2.4.2 Reserve Recognition Accounting (RRA) 2.4.3 Critique of RRA 2.4.4 Summary of RRA

2.5

Historical Cost Accounting Revisited 2.5.1 Comparison of Different Measurement Bases 2.5.2 Conclusion

2.6

The Non-Existence of True Net Income

2.7

Conclusion to Accounting Under Ideal Conditions

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

To Appreciate the Concept of Ideal Conditions

This concept is drawn on throughout the book. Roughly speaking, by ideal conditions I mean conditions where future firm cash flows and interest rates are known with certainty or, if not known with certainty, where there is a complete and publicly known

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set of states of nature and associated objective probabilities which enables a completely relevant and reliable expected present value of the firm to be calculated. I assume risk-neutral investors in this Chapter, so that valuation of the firm is on the basis of expected present value, that is, no adjustment for risk is needed. The concept of a risk-averse investor is introduced in Section 3.4, and a capital asset pricing model of the firm’s shares is described in Section 4.5. 2.

To Use the Present Value Model Under Ideal Conditions to Prepare an Articulated Set of Financial Statements for a Simple Firm

The text limits itself to financial statements for the first year of operations. The problem material extends the accounting to a subsequent year (see problems 1, 2, 3, 5, 15, and 19). In subsequent years, the firm earns interest on opening cash balance. This is picked up by the accretion of discount calculation, since cash is included in opening net assets. Interest earned on cash balances leads naturally to the role of dividends in present-value accounting and the concept of dividend irrelevance. 3.

To Critically Evaluate Reserve Recognition Accounting (RRA) as an Application of the Present Value Model

I usually allow some class time to criticize the assumptions of ideal conditions. Some students want to “blow off steam” because they perceive these assumptions as quite strong. I find that RRA is an excellent vehicle both to motivate and critique present value-based accounting. The fact that it is on line encourages students to take the present value model seriously, which I emphasize by basing class discussion on an example of RRA disclosure for a Canadian oil and gas firm that also reports to the SEC. Such disclosures are usually in SEC Form 40-F, not in the annual report (which says something about management’s view of RRA). I also emphasize the point that present value-based accounting products run into severe implementation problems when the ideal conditions they need do not hold.

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I sometimes receive comments that the text over-emphasizes RRA. I find RRA so helpful to illustrate numerous course concepts that I have resisted such comments. However, instructors may wish to emphasize that RRA, based on a United States accounting standard, is relevant to Canadian oil and gas firms whose shares are traded in the United States. In this regard, it is worth noting that Husky Energy Inc., used as the text RRA illustration in Section 2.4.2, is a Canadian-based corporation. 4.

Historical Cost Accounting in the Mixed Measurement Model

Instructors may wish to discuss historical cost accounting in relation to current value accounting, since historical cost is still an important component of the mixed measurement model. Section 2.5 compares these measurement bases in terms of relevance and reliability, timing of revenue recognition, recognition lag, and matching. This is a good place to emphasize the trade-off between relevance and reliability, and how different measurement bases imply different trade-offs. This is also a good place to discuss the relative importance of the balance sheet and income statements under the two measurement bases. That is, historical cost accounting takes the view that the income statement is of greater importance because it gives the current installment of the firm’s earning power, and provides a place to start to predict future firm performance. Under current value accounting, the balance sheet is of greater performance, the argument being that current values of assets and liabilities provides a better prediction of future firm performance. 6.

To Question the Existence of Net Income as a Well-Defined Economic Construct

I use the reliability problems of RRA to question the existence of “true” economic income except under ideal conditions. With the text example, or some other example, of RRA disclosure in front of us, I ask the students if they would be willing to pay the RRA value for the proved reserves of an oil and gas company. Discussion usually brings out a negative response, for reasons such as difficulties in assessing expected quantities

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and prices, disagreement with a 10% discount rate, possible inside information about costs, additional reserves, etc. I then point out that there are numerous other assets and liabilities for which a quoted market price does not exist, and argue that information asymmetry is a major reason why market prices may not exist. The market for used cars and problems surrounding insurance markets in the presence of adverse selection and moral hazard provide other examples of “missing” markets. Having established that there are not quoted market prices available for “everything,” I point out that it is then impossible to fully value a firm on this basis and, as a result, it is also impossible to measure true economic income. I take a sort of perverse pleasure in asking those students who are heading for a professional accounting career if they really want to devote their lives to measuring something which does not exist. I am careful to end on an upbeat note, however, by pointing out that lack of a true measure of income means that a large amount of judgement is required to come up with a useful measure, and that judgement is the basis of a profession. I usually do not go further than the above intuitive argument that incomplete markets are at the heart of problems of income measurement. However, instructors who wish to dig into incompleteness more deeply and precisely can assign Beaver & Demski’s “The Nature of Income Measurement” (The Accounting Review, January, 1979).

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Suggested Solutions to Questions and Problems 1. P.V. Ltd. Income Statement for Year 2 Accretion of discount (10% × 286.36)

$28.64

P.V. Ltd. Balance Sheet As at Time 2 Financial Asset Cash

Shareholders’ Equity $315.00

Opening balance Net income

$286.36 28.64

Capital Asset Present value

0.00 $315.00

$315.00

Note that cash includes interest at 10% on opening cash balance of $150.

Suppose that P.V. Ltd. paid a dividend of $10 at the end of year 1 (any portion of year 1 net income would do). Then, its year 2 opening net assets are $276.36, and net income would be: P.V. Ltd. Income Statement For Year 2 Accretion of discount (10% × 276.36) 11 .

$27.64

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P.V.’s balance sheet at time 2 would be: P.V. Ltd. Balance Sheet As at Time 2 Financial Asset Cash: (140 + 14 + 150)

Shareholders’ Equity $304.00

Opening balance:

$276.36

(286.36 - 10.00 dividend) Capital Asset, at Present value

Net income

27.64

0.00 $304.00

$304.00

Thus, at time 2 the shareholders have: Cash from dividend

$10.00

Interest at 10% on cash dividend, for year 2 Value of firm per balance sheet

1.00 304.00

$315.00

This is the same value as that of the firm at time 2, assuming P.V. Ltd. paid no dividends (see Question 1). Consequently, the firm’s dividend policy does not matter to the shareholders under ideal conditions. Note that a crucial requirement here, following from ideal conditions, is that the investors and the firm both earn interest on financial assets, including reinvested dividends, at the same rate of return.

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Note also that if the investor spends the dividend rather than investing it, this must be because he/she values current consumption as preferable to investing. Thus, the investor is no worse off if the dividend is spent. Also, if the firm pays no dividend, and the investor wants to consume $10, he/she can borrow at 10%. This liability is offset by the additional $10 increase in firm value on the $10 additional retained earnings. Again, the investor is no worse off. 3.

Expected net income is also called accretion of discount because the firm’s expected future cash flows are one year closer at year end than at the beginning. Consequently, the opening firm value is rolled forward or “accreted” at the discount rate used in the present value calculations.

The procedure here is similar to that used in Question 2. Assume that the good economy state is realized for year 1. Assume also that P.V. Ltd. pays a dividend of, say, $40 at time 1. If the good economy state is also realized in year 2, P.V.’s year 2 net income will then be: P.V. Ltd. Income Statement For Year 2 (good economy in year 2) Accretion of discount [(336.36 – 40) ×.10]

29.64

Abnormal earnings, as a result of good state realization in year 2 (200 – 150)

50.00

Net income year 2

$79.64

PV’s balance sheet at the end of year 2 will then be: P.V. Ltd.

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Balance Sheet As at Time 2 Financial Asset Cash (200 - 40 + 200 + 16)

Shareholders’ Equity $376.00

Opening balance

$336.36

Less: Dividend end Capital Asset

0.00

of year 1

40.00 $296.36

Add: Net income $376.00

79.64 $376.00

Thus, at time 2 shareholders have: Cash from time 1 dividend

$40.00

Interest period 2 on time 1 dividend: $40 ×0.10 Value of firm per balance sheet, time 2

4.00 376.00 $420.00

Note: cash balance of $376 assumes no dividend paid for year 2. If P.V. Ltd. paid no dividend at time 1, the value of the firm at time 2 would be: Cash: 200 + 200 + 20

$420.00

Capital asset

0.00

$420.00

Thus, the shareholders’ wealth is the same at time 2 whether the firm pays a year 1 dividend or not.

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An identical analysis applies if the low state is realized in year 2. Shareholders’ wealth is $320 at time 2 regardless of whether P.V. Ltd. pays a dividend at time 1. A similar analysis applies if the low state is realized in period 1. Therefore, regardless of the state that is realized, shareholders are indifferent to dividend policy. As long as ideal conditions hold, the introduction of uncertainty does not invalidate dividend irrelevancy. 5.

Cash end State realization Probability of year 1

Interest on opening cash balance

Sales year 2 Total

bad, bad

0.25

100

210

bad, good

0.25

100

200

310

good, bad

0.25

200

100

320

good, good

0.25

200

420 $1,260

Thus, the liquidating dividend will be $210, $310, $320, or $420; each with probability 0.25. Thus, present value, at time 0, of expected liquidating dividend is: 𝑃𝐴0 = =

1 [0.25(210 + 310 + 320 + 420)] 1.102

0.25 × 1,260 = $260.33 1.10 2

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Expected cash flow in each year is 0.5 × 100 + 0.5 × 200 = 50 +100 = $150 Assuming no dividends, present value of future cash flows is thus: 𝑃𝐴0 =

1 1 (150 (315) = $260.33, + 15 + 150) = 1.102 1.102

where $15 is the expected return on investing period 1 cash.

Note: it is assumed that state realizations in each period are independent. 6.

The expected value of a single roll of a fair die is: x=

1 × (1 + 2 + 3 + 4 + 5 + 6) = 3.5 6

First, you would have to write down a set of possible states of nature for

the die. One simple possibility would be to define: State 1:

die is fair

State 2:

die is not fair.

Then, subjective probabilities of each state need to be assessed, based on any prior information you have. For example, if the person supplying you with the die looks suspicious, you might assess the probability of state 2 as 0.50, say. A problem with this approach, however, is that to go on to calculate the expected value of a single roll when the die is not fair, you do not have probabilities for each possible outcome of the roll. That is, you do not know just how unfair the die is. A more elaborate alternative would be to formally recognize that the probability of rolling a 1 can be anything from zero to one inclusive, and similarly for rolling a 2, 3, . . . , 6, subject to the requirement that the six probabilities sum to one. Formally, we can regard a state as a 1 × 6 vector 16 .

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P = [ p1, p2, . . . , p6], subject to

pi ≥ 0 i = 1, 2, . . . , 6 ∑ pi = 1

Thus, the set of states consists of all vectors satisfying these requirements. All vectors except the one with all pi = 1/6 represent a different possible bias. Next, it is necessary to assess state probabilities. It is by no means obvious how to do this. You would have to bring to bear any information or subjective feelings that you may have. Lacking any objective information, one possibility is to assume that each possible state is equally likely. Then, the expected value of a single roll is 3.5. This does not mean that you believe the die is fair, even though this is the same answer as in part a. Rather, it means that the various possible biases cancel each other out, since you feel that they are equally likely. Your uncertainty about the true state of the die suggests that you would be interested in any information that would help you refine your subjective probability assessment, which leads to part c. c.

It will never be known with certainty whether the die is fair or not because

luck might influence the outcome of the rolls. However, after a few rolls you should be able to better predict future rolls. Yes, the four rolls should affect your belief that the die is fair because you can calculate the average roll, which is 1/4 (6 + 4 + 1 + 3) = 3.5 here. Since this is exactly the average roll that would be expected if the die was fair, you would probably increase your belief that it is fair. Note: The main purpose of this question is to anticipate what happens when objective state probabilities are not available, in preparation for the introduction of decision making under uncertainty in Section 3.3. The analogy of this question is 17 .

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to the problem of subjectively assessing probabilities over the true state of the firm and of the role of financial statement information in refining these probabilities. Questions 7, 8, and 9 of this chapter can usefully be assigned in conjunction with this question. Alternatively, this question could be assigned as part of Chapter 3.

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Under ideal conditions of certainty, future cash flows are known by assumption. Thus estimates are not applicable. Under ideal conditions of uncertainty, by assumption, there is a complete and publicly known set of states of nature, known cash flows conditional on each state, and objective probabilities of those states. Also, the interest rate to be used for discounting is given. Then, expected present value is a simple calculation that does not require estimates to prepare.

Under non-ideal conditions, it may be difficult to write down a complete set of states of nature and associated cash flows. Even if these can be written down, difficulties remain because objective state probabilities are not available. This is perhaps the most fundamental difficulty, since these probabilities must be subjectively estimated. Also an interest rate is not necessarily given. All of these difficulties lead to reliability problems of lack of representational faithfulness and possible bias. The expected present value calculation can still be made, but it is an estimate because the probabilities and other values that go into it are estimates.

Market value will be affected if the RRA information affects investors’ subjective probabilities of states of nature concerning future firm performance. This could happen, for example, if the RRA statements show an increase or decrease in the present values of proved reserves. This evidence, while highly relevant, suffers from low reliability. Also, it is included in the financial statement notes, not in the financial statements proper. Nevertheless, if the relevance of RRA outweighs its low reliability, investors will increase or decrease their subjective probabilities over states of nature. This would affect their evaluations of future earnings and/or cash flows, their buy/sell decisions, hence the market value of the firm. It can be argued that firm value will not be affected by pointing out that the RRA information may be perceived by investors as so unreliable that they ignore it.

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Relevant information is information that enables investors to estimate the present value of future receipts from an asset (or payments under a liability). In an accounting context, relevant information helps investors to predict future firm performance, such as cash flows. Reliable information is information that faithfully represents what it is supposed to represent. Note: In this book, we use the term relevance to refer to what the Conceptual Framework now calls representational faithfulness. We do this because the term is shorter and familiar from past usage. Instructors who wish to expose students with the Framework terminology may wish to do so in this question. See Chapter 1, Note 14. When conditions are not ideal, the estimation of the present value of future firm cash flows (i.e., relevant information) requires specification of a set of possible future cash flow amounts (i.e., states of nature). The probabilities of these states are subjective, which means that they must be estimated by the preparer. Also, an interest rate must be specified for the discounting calculations. All of these procedures are subject to errors and possible bias, reducing reliability. Thus, like almost all predictions of the future, relevant information tends to be unreliable. Conversely, reliable information, such as the historical cost of a capital asset or the face value of debt, tends to be low in relevance because this basis of valuation involves no direct estimates of future receipts or payments. Rather, cost is based on market transactions at the acquisition date. While, at time of acquisition, historical costs generally reflect estimates of future receipts or payments, they quickly lose relevance since market values, expected future receipts, and interest rates change over time. Then, historical cost-based valuations lose relevance. Therefore, the accountant who tries to secure greater relevance by predicting future events must cope with less reliability. Consequently, these two desirable 20 .

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characteristics of accounting information must be traded off, since an increase in one leads to a decrease in the other.

11.

Several reasons can be suggested why oil company managers have reservations about RRA: •

The discount rate of 10% might not reflect the firm’s cost of capital.

•

Low reliability. RRA involves making a large number of assumptions and estimates. While RRA deals with low reliability in part by requiring average prices of oil and gas for the period to be used (rather than prices anticipated when the reserves are expected to be sold), management may feel that average past prices bear little relationship to the net revenue the company will receive in the future. Furthermore, management may be concerned about low reliability of other estimates, such as reserve quantities.

•

Frequent changes in estimates. Conditions in the oil and gas market can change rapidly, making it necessary for the firm to make frequent changes in estimates.

•

Investors may ignore. Investors may not understand the RRA information. Even if they do, management may believe the RRA information is so unreliable that investors will ignore it. If so, why prepare it?

•

Legal liability. Management may be concerned that if the RRA estimates are not realized, the firm will be subject to lawsuits from investors. Management’s reservations may be an attempt to limit or avoid liability.

12.

Most industrial and retail firms regard revenue as earned at the point of

sale. Since sale implies a contract with the buyer and change of ownership, this 21 .

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is usually the earliest point at which significant risks and rewards of ownership pass to the buyer, the seller loses control of the items sold (e.g.., title passes to buyer) and at which the amount of revenue to be received can be determined with reasonable reliability. b.

Under RRA, revenue is recognized when oil and gas reserves are proven.

This point in the operating cycle does not meet the IAS 18 criteria for revenue recognition. Since the oil and gas are still in the ground and the reserves are not sold, the significant risks and rewards of ownership have not been passed on and control remains with the producer. Also, the large number of revisions to estimates under RRA casts doubt on the reliability of the amount of revenue recognized. Presumably, this is why RRA is presented as supplementary information only. Presumably, however, collection is reasonably assured since oil and gas have ready markets. Note: This question illustrates that the trade-off between relevance and reliability can be equivalently framed in terms of revenue recognition as well as balance sheet valuation. In effect, balance sheet valuation is in terms of the debit side of asset valuation whereas criteria for revenue recognition are in terms of the credit side. The basic trade-off is the same, however. In particular, it should be noted that early revenue recognition increases relevance, even though it may lose reliability. 13.

From a balance sheet perspective under ideal conditions, inventory is

valued at current value. This could be the present value of expected future cash receipts from sale, that is, value-in-use. Alternatively, inventory could be valued at market value, that is, at fair value since under ideal conditions these 2 values would be the same). Note: In the present value examples of this chapter, all production is assumed sold for cash. If all production is not sold, inventory would be valued at current value, and cash would be less by this amount. 22 .

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Since the firm’s balance sheet includes inventory at current value, it is included at current value in the accretion of discount calculation. Thus, in effect, revenue on unsold production is recognized as the inventory is manufactured. b.

Cost basis accounting for inventory is due to lack of ideal conditions.

Then, current value requires estimation, opening up inventory valuation to error and possible manager bias. Accountants must feel that this reduction in reliability outweighs the greater relevance of current inventory value. Historical cost accounting for inventories is not completely reliable, since firm managers still have some room to manage (i.e., bias) their reported profitability through their choice of cost methods (FIFO, LIFO, etc.). Furthermore, even the cost of inventories is not always reliable. For example, overhead costs are usually allocated to the cost of manufactured inventory. These costs are affected by manager decisions about allocation rates and production volumes. Note: it could also be mentioned that historical cost accounting for inventories is accompanied by the lower-of-cost-or-market rule. Then, reliability issues of estimating current valuation re-arise. Also, it is possible that the firm may attempt to hide obsolescence by not writing down obsolete inventory at all. 14.

This practice implies that revenue is recognized as cash is collected. This basis of valuation might be used if the firm sells with little or no money down and a long collection period. Valuation of accounts receivable at the amount of the sale would require estimating credit losses. This estimate may be too unreliable under these conditions, outweighing the greater relevance of recognizing revenue as a sale is made.

15.

Present value of capital asset 2015, 2016, and 2017

23 .

Scott, Financial Accounting Theory, 7th Edition

PA0 =

Instructor’s Solutions Manual Chapter 2

600 600 600 + + = 566.04 + 534.00 + 503.77 = $1,603.81 2 1.06 1.06 1.06 3

PA1 = 566.04 + 534.00 = $1,100.04 PA2 = $566.04 Sure Corp. Balance Sheet As at December 31, 2015

Cash (600 – 50)

$550.00

Shareholders’ equity

Capital asset, at

Capital stock

present value

$1,100.04

$1,603.81

Retained Earnings Net income 96.23 Dividend

(50.00)

$1,650.04

46.23

$1,650.04

Sure Corp. Income Statement For the year ended December 31, 2015 Accretion of discount (1,603.81 × .06) b.

$96.23

Sure Corp. Balance Sheet As at December 31, 2016 Cash (550 + 600 + 33 – 50) .

$1,133.00 24

Shareholders’ equity

Scott, Financial Accounting Theory, 7th Edition

Instructor’s Solutions Manual Chapter 2

Capital asset, at

Capital stock

present value

566.04

$1,603.81

Retained earnings

$1,699.04

95.23 $1,699.04

Note: Cash includes $550 × .06 = $33 interest on opening cash balance. Retained earnings calculated as $46.23 + 99.00 – 50 = $95.23

Sure Corp. Income Statement For the year ended December 31, 2016 Accretion of discount (1,650.04 × .06)

$99.00

Under ideal conditions, present value and market value are equal. This is

because of arbitrage. Under real conditions, market values provide only a partial implementation of fair value accounting. If reliable market values are available, fair values based on market prices provide a useful trade-off between relevance and reliability. However, because of incomplete markets, market values are not available for all assets and liabilities. Then, estimates of fair value, such as the market value of related assets and liabilities, reversion to value-in-use, or models, are needed. These problems complicate the implementation of fair value accounting due to possible low reliability. 25 .

Scott, Financial Accounting Theory, 7th Edition d.

Instructor’s Solutions Manual Chapter 2

The main reason for low reliability is the difficulty of estimating expected

future cash flows, which would require a set of possible future cash flows (states of nature) and subjective probabilities of these states. Since, under realistic conditions these estimates are subject to error and possible manager bias, reliability is reduced. Another reason arises from possible error and bias in the choice of interest rate for discounting. However, the prime bank rate and central bank rate are available as proxies. Low reliability does not necessarily mean that present value-based accounting is not decision useful, since present values are high in relevance. These two desirable characteristics of accounting information must be traded off. If the benefit of higher reliability exceeds the danger of lower reliability, present value accounting is decision useful. 16.

P Ltd. Balance Sheet As at End of First Year

Financial Asset Cash (note 1)

Liabilities $1,137.40

Capital Asset, at present value (note 2)

Bonds outstanding (note 3) $616.00 Shareholders’ Equity

2,200.00

Capital stock issued (note 4) 2,474.00 Net income (note 5) 247.40

$3,337.40

2,721.40 $3,337.40

Notes: 26 .

Scott, Financial Accounting Theory, 7th Edition

Instructor’s Solutions Manual Chapter 2

Cash = $1,210.00 cash flow - 72.60 (605 × 0.12) interest paid on bonds = $1,137.40

Book value of asset = PV end of year 1 = (2,000 + 420)/1.10 = $2,200

Bonds outstanding = PV at end of year 1 = (72.60 int. yr. 2 + principal due of 605)/1.10 = $616

Capital stock is issued in the amount of cost of asset less proceeds of bonds: 3,100 − [

72.60 72.60 + 605 + ] 1.10 1.10 2

= 3,100 − (66 + 560) = 3,100 − 626 = $2,474

Net income for year 1 calculated as $2,474 × .10 = $247.40

Note: Purchase price of capital asset can be verified as: 1,210/1.10 + 2,000/(1.10)2 + 420/(1.10)2 = $3,100 Note: An alternative net income solution, equally acceptable, is: Accretion of discount $3100 × 0.10 = $310.00 Less interest accrued on opening present value of bonds $626 × 0.10 = 62.60 Net Income

$247.40

In this case, discount is accrued on the opening value of the capital asset, with a deduction for interest accrued on the debt. b.

Ideal conditions are unlikely to hold because:

27 .

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Instructor’s Solutions Manual Chapter 2

It is unlikely that future cash flows from the fixed asset can be accurately forecast.

•

It is unlikely that there is a single interest rate in the economy, and interest rates may change over time.

If ideal conditions do not hold, expected income is likely to be different

than the amount calculated in part a of $247.40. When ideal conditions do not hold it is likely that the amounts and/or timing of expected future cash flows will change over the year. This gives rise to changes in estimates (i.e., abnormal earnings), which will be reflected in net income for the year. Another reason why net income may change from expected is that interest rates may change, which would also change the present value of future cash flows. The resulting change in present value will be reflected in net income for the year.

17.

Expected present value of North Ltd’s asset on August 1, 2015 and July

31, 2016:  900 900   300 300  PA0 = 0.7  + + 0.3 + 2 2 1.03 1.03  1.03 1.03  = 0.7(873.79 + 848.34 ) + 0.3(291.26 + 282.78) = 0.7 × 1722.13 + 0.3 × 574.04 = 1,205.49 + 172.21 = 1,377.70

900 300 + 0.3 × 1.03 1.03 = 0.7 × 873.79 + 0.3 × 291.26 = 611.65 + 87.38 = 699.03

PA1 = 0.7 ×

North Ltd. 28 .

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Balance sheet As at July 31, 2016 Cash (900 – 15 - 50)

$835.00

Bank loan

$500.00

Shareholders’ equity Capital asset, at

Capital stock (PA1)

present value

699.03

877.70

Retained earnings (206.33 – 50)

156.33 1,034.03

$1,534.03

North Ltd. Income Statement For the year ended July 31, 2016

Expected net income (accretion of discount) (877.70 × .03)

$26.33

Abnormal earnings: Expected cash flow (0.7 × 900) + (0.3 × 300) = (630 + 90) = $720.00 Actual cash flow

900.00 180.00

Net income for the year

$206.33

Note: An alternate solution, equally acceptable, is: 29 .

Scott, Financial Accounting Theory, 7th Edition

Instructor’s Solutions Manual Chapter 2

Accretion of discount $1,377.70 × 0.03 =

$41.33

Less interest accrued on bank loan $500 × 0.03 = 15.00 26.33

Abnormal earnings, as above

180.00

Net income

$206.33

The implied revenue recognition timing is on a present value basis. That is, discounted expected future revenue is capitalized into capital asset on the balance sheet. Income for the period is thus interest on the opening capitalized balance plus or minus the difference between expected and actual cash flow for the period Note: An alternative answer, equally acceptable, is that revenue is recognized as changes in current value occur. Here, the current value of operating cash increased by ($900 – 15 =) $885 during the year, and the current value of equipment decreased by (1,377.70 – 699.03 =) $678.67, giving net income of $206.33. c.

Net income for the year ended July 31, 2016 on a historical cost basis: Sales (900) minus amortization expense (1,377.70/2 = 688.85) gives net income of $211.15 for the year ended July 31, 2016.

The present value-based income statement is more relevant, since it is based on the present value of future cash flows. However, the historical cost-based income statement is more reliable, since, in the absence of ideal conditions, the present value-based statement requires estimates of future cash flows, probabilities, and the interest rate. When ideal conditions do not hold, these estimates are subject to error and possible manager bias.

30 .

Scott, Financial Accounting Theory, 7th Edition 18.

Instructor’s Solutions Manual Chapter 2

Under ideal conditions, the amount paid for an asset equals its expected

present value. Expected present value of Electro’s assets on January 1, 2015:  900 1200   600 600  PA0 = 0.6  + + 0.4  + 2 2 1.03 1.03  1.03 1.03  = 0.6(873.79 + 1131.12 ) + 0.4(582.52 + 565.56 ) = 0.6 × 2004.91 + 0.4 × 1148.08 = 1202.94 + 459.23 = 1662.17

Present value of assets on Jan. 1, 2016 also required to answer part b:

1200 600 + 0.4 × 1.03 1.03 = 0.6 × 1165.05 + 0.4 × 582.52 = 699.03 + 233.01 = 932.04

PA1 = 0.6 ×

Electro Ltd.

Balance Sheet As at December 31, 2015 Cash (900 – 60)

$840.00

Shareholders’ equity

Capital asset, at present value

Capital stock (PA0)

$1,662.17

932.04

Retained earnings (169.87 – 60) 109.87

$1,772.04

Electro Ltd. Income Statement For the year ended December 31, 2015 31 .

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Expected net income (accretion of discount) (1,662.17 × .03)

$49.87

Abnormal earnings Expected cash flow (0.6 × 900) + (0.4 × 600) = (540 + 240) $780.00 Actual cash flow

900.00 120.00

Net income for the year

$169.87

The main reason is that ideal conditions do not prevail in practice. The

high relevance of present value-based accounting remains. However, lack of ideal conditions creates concern about reliability of present value-based amortization, since estimates of future cash flows are subject to error and possible managerial bias. Furthermore, attempts to use market values (i.e., fair values) in place of present values run into market incompleteness. It seems that, for much property, plant and equipment, increased relevance of current values is outweighed by decreased reliability. In addition, present values and/or fair values of property, plant, and equipment are volatile, since future cash flows and market values are usually highly dependent on the state of the economy. This creates volatility of net income. Managers dislike high net income volatility, particularly if they believe that the volatility does not reflect their performance in managing the company.

19.

Under ideal conditions, the amount paid for an asset equals its present

value:

32 .

Scott, Financial Accounting Theory, 7th Edition

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100 200 100 50 ) + 0.4( ) PA0 = 0.6( + + 2 1.06 1.06 1.06 1.06 2 = 0.6(94.34 + 178.00) + 0.4(94.34 + 44.50) = 0.6 × 272.34 + 0.4 × 138.88 = 163.40 + 55.55 = 218.95

b. QC Ltd. Statement of Net Income For the Year ended December 31, 2016 Accretion of discount (232.08 ×.06)

$13.92

Abnormal earnings Expected cash flow (0.6 × 200 + 0.4 × 50)

140.00

Actual cash flow (high state)

200.00

Net income for the year

60.00 $73.92

Note: Calculation of accretion of discount requires QC Ltd. net worth as at end of 2010: Capital stock (= cost of capital asset)

$218.95

Net income 2010 (218.95 × .06)

13.13

Net worth, December 31, 2010

$232.08

Alternative calculation: Cash

$100.00

Present value of capital asset

0.6(200/1.06) + 0.4(50/1.06) = 113.21 + 18.87 =

132.08 $232.08

c. QC Ltd. Balance Sheet As at December 31, 2016

33 .

Scott, Financial Accounting Theory, 7th Edition Current asset Cash (100 + 200 + 6)

Instructor’s Solutions Manual Chapter 2 Capital stock

$306.00

Capital asset, at present value

$218.95

Retained earnings

0.00

Net income, 2015 13.13 Net income, 2016 73.92 87.05

$306.00

34 .

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20.

Instructor’s Solutions Manual Chapter 2

Note: In this problem, state probabilities are not independent over time. Part b of this question requires calculations not illustrated in the text. a.

The cost of the machine equals its present value as at time zero:

PV0 =

1 (0.75 × 1,000 + 0.25 × 3,000) 1.08 1 [0.25(0.60 × 1,000 + 0.40 × 3,000) + 0.75(0.10 × 1,000 + 0.90 × 3,000)] + 1.08 2

1 (750 + 750) + 1 2 [0.25(600 + 1,200) + 0.75(100 + 2,700)] 1.08 1.08

1 1 (0.25 × 1,800 + 0.75 × 2,800) × 1,500 + 1.08 1.08 2

= 1,388.89 +

1 (450 + 2,100) 1.08 2

= 1,388.89 + 2,186.21 = $3,575.10

1 (0.6 × 1,000 + 0.4 × 3,000) 1.08 1 = (600 + 1,200) 1.08 1,800 = = $1,666.67 1.08

PV1 =

b. Conditional Ltd.

35 .

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Income Statement for Year 1 (No major failure) Accretion of discount (expected net income) (3,575.10 × .08 = $286.01)

$286.01

Abnormal earnings Year 1: Expected cash flows (0.75 × 1,000 + 0.25 × 3,000) 1,500.00 Actual cash flows

3,000.00

1,500.00

Year 2: Original expected cash flows:

(0.75 × 2,800 + 0.25 × 1,800)

2,550.00

Revised expected cash flows resulting from year 1 state realization:

(0.60 × 1,000 + 0.40 × 3,000)

1,800.00

Reduction in year 2 expected cash flows

750.00

Present value of reduction: (750/1.08)

(694.44)

Net Income

$1,091.57

c. Conditional Ltd. Balance Sheet as at End of Year 1 (No major failure) Financial Asset Cash

Shareholders’ Equity $3,000.00

Capital Asset,

Capital Stock Retained Earnings

36 .

$3,575.10

Scott, Financial Accounting Theory, 7th Edition at present value

1,666.67

Instructor’s Solutions Manual Chapter 2 Net income for the year

$4,666.67

37 .

1,091.57 $4,666.67

Scott, Financial Accounting Theory, 7th Edition

20.

Instructor’s Solutions Manual Chapter 2

Present value at January 1, 2015: 7,000 6,000 5,000 + + 1.10 1.10 2 1.10 3

= $15,078.89 Present value at December 31, 2015, based on revised estimates: 6,500 6,000 + 1.10 1.10 2

= $10,867.77 ABC Ltd. Income Statement from Proved Oil and Gas Reserves For the Year Ended December 31, 2015 Accretion of discount (15,078.89 × 0.10)

$1,507.89

Changes in estimates: Shortfall in 2011 revenue (7,000 - 6,500)

($500.00)

Increase in present value of future revenue

1,280.99

780.99 $2,288.88

Increase in present value of future revenue is calculated as follows: Revised present value at December 31, 2015

$10,867.77

Original present value at December 31, 2015 6,000 5,000 = + 1.10 1.10 2 .

9,586.78 38

Scott, Financial Accounting Theory, 7th Edition

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Increase in present value of future revenues

$1,280.99

Note: While not required as part of the question, ABC’s balance sheet as at December 31, 2015, is: Cash

$6,500.00

Capital stock

Oil well, at P.V.

10,867.77

Retained earnings

$17,367.77 b.

$15,078.89 2,288.88 $17.367.77

Possible concerns arise from the low reliability of reserves estimates, and

include: •

Reserve quantity estimates are subject to error.

•

The timing of extraction may differ from estimate.

•

Changes in price and cost estimates. Due to the number of assumptions about oil prices and costs in the present value calculations, the estimated future cash flow amounts might not reflect the amount of net revenue the firm will actually receive in future periods.

•

Lawsuits. The expected future cash flows may not represent fair market value of reserves. Management may fear this will mislead investors, possibly leading to lawsuits.

22.

HL Oil & Gas Ltd. Income Statement from Proved Oil and Gas Reserves For the Year 2015

Accretion of discount

$700

Abnormal Earnings: Present value of additional reserves added during the year Unexpected items: Changes in prices .

1,200 39

1,500

Scott, Financial Accounting Theory, 7th Edition

Instructor’s Solutions Manual Chapter 2

Changes in quantities

(200)

1,000

Net income for the year

$3,200

The reason derives from concerns about reliability of the reserves

estimates. The standard setters must have believed that while unproved reserves information is highly relevant, they could not be valued with sufficient reliability that the resulting estimates were decision useful.

Again, the reason derives from reliability concerns. Allowing each firm to

choose its own discount rate opens up the possibility of manager bias, whereby the rate is chosen to achieve a desired present value. A disadvantage is that when conditions are not ideal, different firms may have different costs of capital. This can arise, for example, from operating in different countries and in different geographical conditions. Then, mandated discount rates may not reflect the reserves’ riskiness. This would reduce decision usefulness. 23.

FX Energy, Inc. Income Statement for 2015

Expected net income—accretion of discount

$546

Abnormal earnings: Present value of additional reserves proved during the year

2,511

Unexpected items-changes in estimates Net changes in prices and production costs

(159)

Changes in estimated future development costs

(53)

Revisions in previous quantity estimates 40 .

(31)

Scott, Financial Accounting Theory, 7th Edition

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Changes in rates of production and other

116

Net income from proved oil and gas reserves b.

(127) 2,384 $2,930

RRA net income of $2,930 differs from the historical cost-based loss of

$5,245 because of differences in the timing of revenue recognition. Under historical cost accounting, revenue is recognized when the reserves are lifted and sold. Under RRA, revenue is recognized as reserves are proved. Then, RRA net income consists of accretion of discount on the opening present value of proved reserves, adjusted for abnormal earnings (i.e., corrections of opening present value). For FX Energy, Inc., the main reason for the large abnormal earnings is the proving of $2,511 of additional reserves during the year. Under historical cost accounting, this amount is not yet recognized as revenue. c.

The reason derives from concerns about reliability of the reserves

estimates. Information about all reserves, and their expected future cash flows, would be highly relevant. However, the designers of the RRA standard must have felt that the low reliability of unproved reserves valuations would outweigh the increased relevance. That is, unproved reserve quantities are subject to even greater reliability concerns than proved reserves. and thus are unlikely to be decision useful. d.

Again, the reason derives from reliability concerns. Allowing each firm to

choose its own discount rate opens up the possibility of manager bias, whereby the rate is chosen to achieve a desired present value. A disadvantage is that when conditions are not ideal, different firms may have different costs of capital. This can arise, for example, from operating in different countries and in different geographical conditions. Then, relevance is decreased since the reserves’ present value at 10% will not reflect the riskiness, hence the required rate of return, of those reserves.

41 .

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Instructor’s Solutions Manual Chapter 2

a. Moonglo Energy Inc. Income Statement for Proved Oil and Gas Operations For year 2015 RRA Basis

Accretion of discount

$125

Present value of additional reserves added during year

162

Unexpected items: Changes in previous year’s estimates

134

Net income from proved reserves for the year

$421

Note: Items on the statement of changes in proved reserves not included in the income statement above ((456), (4), 629) represent cash receipts and disbursements during the year, whereas the items on the income statement above represent non-cash changes. An income statement based on cash receipts and disbursements less amortization expense yields the same result:

Sales (456 + 4)

$460

Development costs incurred in year

(629)

Amortization “income” – increase in balance of proved reserves in year (1,660 – 1070)

590

Net income

$421

See Notes 8 and 11 of this chapter.

42 .

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Profit on a historical cost basis differs from RRA net income because of

different bases of revenue recognition. Under RRA, income is recognized as reserves are proved. Under historical cost, income is recognized as sales are made. Since proving of reserves precedes sales, the two income measures will differ. Here, since the standardized measure increased for the year (i.e., an increase in proved reserves), RRA net income exceeds historical cost net income. Under historical cost, increases in the value of reserves are not recognized until the reserves are sold.

RRA is more relevant, since it records revenue earlier than historical cost.

In effect, revenue is recognized as reserves are proved, rather than when sold as under historical cost. This gives the financial statement user an earlier reading of future firm performance.

If a balance sheet was prepared on an RRA basis, inventory of proved oil and gas reserves would be valued at average selling prices for the year, rather than at historical cost. Again, this is more relevant since selling price of inventory gives a better measure of future firm performance than historical cost, assuming reasonable reliability.

Note: Relevance would be even greater if proved reserves were valued at expected selling prices, as would be the case under ideal conditions.

RRA is less reliable than historical cost both because of possible errors in estimating amounts of reserves and their production and development costs, and possible manager bias. Under RRA, changes are often quite material. Here, changes to previous estimates ($134), which could possibly be due to errors or bias in earlier estimates, exceed expected net income for the year ($125).

Note: Changes in estimates which do not result from error or bias introduce volatility into present values, but are not themselves a source of unreliability. 43 .

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From the information available, we do not know the reasons for the estimate changes. 25.

The most relevant point of revenue recognition is at the beginning of the

operating cycle. For a manufacturing firm, this would be as raw materials and other components of manufacturing cost are acquired and production begins. For an oil and gas firm, this would be as reserves are discovered. For a retail firm, this would be as merchandise is acquired. For a firm with long-term contracts, this would be when the contract is signed. Indeed, one could envisage revenue recognition even earlier than this. For example, for a manufacturing firm, revenue could be recognized when acquisition of manufacturing capacity begins, consistent with accounting under ideal conditions. For an oil and gas firm, revenue could be recognized as reserves are estimated based on geological data. The most reliable point of revenue recognition is as cash is collected from sales and services. b.

Points to consider:

•

Lucent has an incentive to recognize 2000 revenue early to try to prevent its reported net income from falling below 1998 and 1999 levels.

•

The earlier revenue is recognized, the greater the relevance.

•

Early revenue recognition sacrifices reliability, since amounts and timing of cash collections become more difficult to predict.

•

It is questionable whether the significant risks of ownership have not been transferred to the buyer with respect to merchandise shipped to distribution partners. Similar questions arise concerning whether Lucent has lost control of the items, revenues can be measured reliably, and whether collection is reasonably assured. 44 .

Scott, Financial Accounting Theory, 7th Edition •

Instructor’s Solutions Manual Chapter 2

Revenue recognition on partial shipments may violate the conventional point of sale criterion. However, if these shipments are part of a long-term contract, revenue recognized as goods are shipped may be consistent with the criterion of revenue recognition as the work progresses.

•

Lucent’s treatment of vendor financing appears to contradict the criteria. While, technically, products may have been sold, credits granted to assist the customer to finance purchases increase credit risk, reducing assurance about the amounts that will ultimately be collected.

A reasonable conclusion is that Lucent has been overly aggressive in recognition of revenue. The necessity to restate 2000 revenue suggests that the significant risks and rewards of ownership had not been transferred to the buyer and that control of items shipped had not been relinquished. c.

Ownership interest in the customer increases problems of reliable

estimation of the amounts that will ultimately be collected. The vendor’s revenue will be biased upwards and the likelihood of collection reduced if it uses its influence to force goods and services on the customer beyond the point where the customer can sell and pay for the goods and services in the normal course of business. This appears to have happened in the case of Lucent in 2000. 26.

Relevant information is information that enables the prediction of future

firm performance, such as future cash flows. Early revenue recognition anticipates these future cash flows, hence it is relevant. Thus, Qwest’s revenue recognition policy provided relevant information. b.

Reliable information is information that faithfully represents the firm’s

financial position and results of operations. When significant risks and rewards of ownership are transferred to the buyer and the seller loses control over the items transferred, the amount of future cash flows is determined with reasonable representational faithfulness and verifiability, since the purchaser has an obligation to pay. Also, if the amount of cash to be received is determined in an 45 .

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arms-length transaction, the amount of sale is reliable due to lack of possible manager bias. It seems that Qwest’s revenue recognition policy met none of these reliability criteria. The future cash flows were not representationally faithful since there appeared to be no provision for returns, obsolescence, or unforeseen service costs. Furthermore, as evidenced by the later SEC settlements, substantial manager bias is apparent. Obviously, amounts ultimately collectible were not reasonably assured, since the SEC concluded that Qwest had inflated its revenues. c.

Under ideal conditions, revenue is recognized as production capacity is

acquired, since future revenues, or expected revenues, are inputs into the present value calculations. The balance sheet valuations of capital assets incorporate these revenue projections. For an oil and gas company, revenue recognition is analogous—revenue is recognized as reserves are discovered or purchased. The reason for recognizing revenue early is that under ideal conditions, future cash flows, or expected future cash flows, are perfectly reliable, being based on publicly known sets of states of nature and objective state probabilities. There is thus no sacrifice of usefulness in recognizing revenue as early as possible. Note: A superior answer will point out that under ideal conditions net income consists of interest on opening present value (i.e., accretion of discount), plus or minus abnormal earnings under ideal conditions of uncertainty). These are not operating revenues, however, but simply an effect of the passing of time. 27.

a. Manulife Financial Corporation Income Statement, Embedded Value Basis Year Ended December 31, 2011 46 .

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Accretion of discount

$2,808

Abnormal earnings New business during the year

1,086

Unexpected items-changes in estimates Experience variances, etc.

(5,041)

Discount rate changes

(2,416)

Changes in exchange rates

1,171 (6,286)

Net loss for the year

($2,392)

The most likely reason is low reliability of the embedded value. Without an

audit to check the calculations, embedded value is subject to calculation error and possible bias due to manager manipulation. Consequently, investors perceive less information asymmetry only when the value is audited. A related reason is that firms belonging to CFO Forum, which supports transparent reporting, are perceived by investors as committed to voluntarily reporting embedded value and, presumably, committed to its reliable reporting regardless of whether the news is good or bad. Without such commitment, investors may fear that management would discontinue reporting embedded value should it contain bad news. Thus membership in CFO Forum reinforces the effect of the audit. c.

One reason for the difference follows from the arguments in b. Since it

appears that Manulife neither has its embedded value audited nor belongs to CFO Forum, investors may ignore the embedded value per share. Another reason is that investors may be concerned about the substantial 2011 reduction in new business from $1,841 in 2010 to $1,086. Since embedded value 47 .

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does not include expected new business in future years, investors may be concerned that the 2011 new business reduction will continue. Also, the loss of $2,416 from changes in discount rates indicates that Manulife raised the rate it uses to discount future receipts from its business in place. This may be interpreted by investors that Manulife has become more risky. To the extent that investors are collectively risk-averse, this will lower the value they place on Manulife shares. Note: Other possible reasons, which anticipate text topics not yet covered, include: •

Investors may be concerned about the reduction in embedded value for the year of (39,303 – 36,065) $3,238, without realizing that this reduction includes dividends of $846. Net loss in part a of $2,392 is somewhat less pessimistic.

•

Investors may not realize that some of the embedded value items may not persist, such as the unfavourable experience variances of $5,041.

•

General economic conditions may be poor, leading to investor pessimism and low stock prices for all firms.

28.

The National Instrument 51-101 disclosures are more relevant than those

of RRA. Reasons include: •

Information about probable reserves is given in addition to information about proved reserves.

•

Future revenues are evaluated using forecasted prices as well as year-end prices. RRA uses only average oil and gas prices for the period.

•

Unlike RRA, future net revenues are discounted at several different interest rates. This allows the investor to choose that rate closest to his/her 48 .

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estimate of the firm’s cost of capital. This rate could vary, for example, due to location of reserves or current interest rates in the economy. b.

Points to consider:

•

A reasonably precise definition of proved reserves and unproved reserves. This adds to representational faithfulness.

•

Reserves information must be verified by a qualified independent professional and reviewed by the Board of Directors. This adds to representational faithfulness.

•

Use of forecasted prices reduces reliability to the extent that forecasted prices are more subject to errors of estimation and possible bias than year end or average period prices. Note, however, that volatility of prices per se is not a source of unreliability. Thus, assuming no valuation errors or biases, changes in reserves values as forecasted prices change capture the real volatility faced by the firm. Real volatility should not be hidden since this is information that investors may find useful.

•

To the extent that estimation of unproved reserves is more subject to error and possible bias than for proved reserves, reliability of total proved plus probable reserves is lowered. Disclosure of only proved reserves avoids this source of unreliability.

Reasons for the disclaimer:

•

Companies may be concerned about the reliability of their estimates, and wish to alert investors to this possibility.

•

Companies may be concerned that if future revenues differ from those forecasted, they may be subject to lawsuits. Disclaimers should help defend against such suits.

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Managers may be concerned that their reputations will be adversely affected if future revenues differ from forecast. Disclaimers should help protect their reputations.

29.

A theoretically correct measure of income is the net income of a firm for a

period calculated on a present value basis; that is, accretion of discount on opening firm present value, plus or minus any differences between expected and actual cash flows for the period. Alternatively, net income is theoretically correct if it is calculated so as to include the changes during the period in the market values of all assets and liabilities, adjusted for capital transactions (providing that the markets for all assets and liabilities exist and work reasonably well). b.

A theoretically correct measure of income does not exist because ideal

conditions do not exist. As a result, future cash inflows and outflows from assets and liabilities cannot be reliably estimated. This means that present value-based net income is not theoretically correct since theoretical correctness requires complete reliability. Furthermore, market incompleteness can exist in the absence of ideal conditions. Then, properly working market values for all assets and liabilities of a firm need not exist. As a result, net income based on net changes in market values is not theoretically correct either. c.

Historical cost accounting is reasonably reliable because the cost of an

asset is usually an objective and verifiable number. However, while cost is also relevant at time of acquisition, it may lose relevance over time due to changes in market prices, interest rates and economic conditions, which will change the asset’s current value. To the extent reasonably-working market prices exist, current value accounting is more relevant than historical cost while retaining reliability. However, if such market values do not exist, current valuation requires estimates of fair value, cash flow estimates, or the use of models. Estimates of 50 .

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cash flows face serious problems of reliability, as do the inputs into valuation models. Similar considerations apply to liabilities. If a reasonably-working market value exists for a liability (e.g., long term debt, certain derivative financial instruments), fair value provides both a relevant and reliable current valuation. If historical cost accounting ignores such value, it sacrifices relevance with little or no increase in reliability. However, if current value of a liability must be estimated on the basis of future cash outflows or by use of models, similar trade-offs as for assets exist. For example, the carrying value of long term debt is not necessarily adjusted for changes in interest rates or for changes in the credit standing of the issuer. Such changes are highly relevant to investors, but are subject to reliability concerns to the extent that a well-working market value does not exist (e.g., the debt may not be traded). Also, substantial reliability issues exist for current values of other liabilities, such as leases and post-retirement benefits, which do not typically have market values. Overall, we may conclude that historical cost accounting sacrifices considerable relevance in order to attain reasonable reliability.

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Additional Problems 2A-1.

Note: In this problem, state probabilities are not independent over time. XYZ Ltd. purchased an asset on January 1, 2005 with a useful life of two years, at the end of which time it has no residual value. The cash flows from the asset are uncertain. If the economy turns out to be “normal,” the asset will generate $4,000 in cash flow each year; if the economy is “bad,” it will generate $3,000 in cash flow per year; and if the economy is “good,” the cash flow generated will be $5,000 per year. Cash flows are received at year-end. In each year, the chances of a “normal” economy being realized are 30%, the chances of a “bad” economy are 50%, and the chances of a “good” economy are 20%. State realization for both years becomes publicly known at the end of 2005, that is, if the normal state happens for year 1, it will also happen for year 2, etc. Assumptions •

Ideal conditions hold under uncertainty.

•

The economy-wide interest rate is 10%.

•

XYZ Ltd. finances the asset purchase partly by a bond issue and partly by a common share issue. The bond has a $3,000 face value and a 10% coupon rate and matures on December 31, 2001.

•

XYZ Ltd. has adopted the policy of paying out 50% of its net income as dividends to its shareholders.

•

The economy turns out to be “good.”

Required a.

Calculate the present values of the asset at January 1, 2005, and

December 31, 2005. 52 .

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Prepare the present value-based income statement of XYZ Ltd. for the

year ended December 31, 2005. c.

Prepare the present value-based balance sheet of XYZ Ltd. as at

December 31, 2005. d.

Explain why, even under uncertainty, present value-based financial

statements are both relevant and reliable provided ideal conditions hold. e.

Explain why shareholders of XYZ Ltd. are indifferent to whether they

receive any dividend from the company. 2A-2. Relevant Ltd. operates under ideal conditions of uncertainty. Its operations are highly dependent on the weather. For any given year, the probabilities are 0.3 that the weather will be bad and 0.7 that it will be good. These state probabilities are independent over time. That is, the state probabilities for a given year are not affected by the actual weather in previous years. Relevant Ltd. produces a single product for which the demand will fall to zero at the end of 2 years. It produces this product using specialized machinery, which will have no value at the end of 2 years. The machinery was purchased on 1 January, 2005. It was financed in part by means of a bank loan of $2,000 repayable at the end of 2006, with the balance financed by capital stock. No dividends will be paid until the end 2006. Interest on the bank loan is payable at the end of each year. The interest rate in the economy is 6%. Cash flows are not received until the end of each year. Amounts of cash flows for each year are given in the following payoff table:

State

Probability

Cash Flow

Year 1

Year 2

Bad weather

0.3

$600

$400

Good weather

0.7

$6000

$3000

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State realization for 2005 is good weather. Required a.

Prepare, in good form, a balance sheet for Relevant Ltd. as at the end of

2005 and an income statement for 2005. b.

As at January 1, 2006, how much is expected net income for 2006?

Explain why the financial statements you have prepared in part a are both

completely relevant and completely reliable. 2A-3. An area where discounting could possibly be applied is for future income tax liability resulting from timing differences. Consider a firm that purchases an asset costing $100,000 on January 1 of year 1. It is amortized on a straight-line basis at 20% per year on the firm’s books. Tax amortization is 40% on a declining balance basis. The income tax rate is 45%. The following schedule shows a simplified calculation of the income tax liability balance for this asset over its life, assuming zero salvage value. This is the firm’s only capital asset. StraightOpening

Tax

Line

Year Tax B.V.

Additions

Amortization

Difference

—

$100,000

$40,000

$20,000

60,000

24,000

20,000

4,000

36,000

14,400

20,000

(5,600)

21,600

8,640

20,000

(11,360)

12,960

12,960*

20,000

(7,040)

Tax on

Income Tax .

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Liability

9,000

1,800

10,800

(2,520)

8,280

(5,112)

3,168

(3,168)

Instructor’s Solutions Manual Chapter 2

*It is assumed that all of the remaining tax book value is claimed in year 5. Required a.

Calculate the discounted present value of the future income tax liability at

the end of each of years 1 to 5. Use a discount rate of 12%. b.

Why are the balances calculated in part a different from the undiscounted

income tax liabilities? c.

What problems would there be if the discounting approach was applied to

the tax liability of a large, growing firm with many capital assets? 2A-4. On January 1, 2005, GAZ Ltd. purchased a producing oil well, with an estimated life of 15 years, and started operating it immediately. The management of GAZ Ltd. calculated the present value of future net cash flows from the well as $1,500,000. The discount rate used was 10%, which is the company’s expected return on investment. During 2005, GAZ Ltd. recorded cash sales (net of production costs) of $600,000. GAZ Ltd. also paid $50,000 cash dividends during 2000. Required a.

Prepare the income statement of GAZ Ltd. for the year ended December

31, 2005, using RRA.

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Prepare the balance sheet of GAZ Ltd. as at December 31, 2005, using

RRA. c.

Summarize the perceived weaknesses of RRA accounting.

Why does SFAS 69 require that a 10% discount rate should be used by all

oil and gas firms rather than allowing each firm to select its own discount rate? 2A-5 Rainy Ltd. operates under ideal conditions of uncertainty. Its cash flows depend crucially on the weather. On January 1, 2010, Rainy acquired equipment to be used in its operations. The equipment will last two years, at which time its salvage value will be zero. Rainy financed the equipment purchase by issuing common shares. In 2010, net cash flows will be $700 if the weather is rainy and $200 if it is dry. In 2011, cash flows will be $900 if the weather is rainy and $300 if it is dry. Cash flows are received at year-end. In each year, the probability that the weather is rainy is 0.3 and 0.7 that it is dry. The interest rate in the economy is 6% in both years. Rainy pays a dividend of $50 at the end of 2010. Required a.

In 2010, the weather is rainy. Prepare a balance sheet as at the end of

2010 and an income statement for 2010. b.

If we attempt to apply the present value model under uncertainty to the

more realistic conditions under which accountants operate, the expected present value calculations often become unreliable. Explain why. c.

Explain why well-defined (i.e., “true”) net income does not exist under the

realistic conditions under which accountants operate. In place of true net

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income, what criterion have accountants adopted to guide their financial accounting and reporting decisions?

Suggested Solutions to Additional Problems 2A-1. a.

Expected present value of asset on January 1, 2005:  3,000 3,000   5,000 5,000   4,000 4,000  0.50  + 0.30  + + 0.20  + + 2  2  2   1.10 1.10   1.10 1.10   1.10 1.10 

= $2,603.31 + 2,082.65 + 1,735.54 = $6,421.50

Expected present value of asset on December 31, 2005, given “good” economy: 5,000/1.10 = $4,545.45 Note: PV of bonds payable = $3,000 (equal to face value because market interest rate equals coupon rate) b. XYZ Ltd. Income Statement For the Year Ended December 31, 2005

Accretion of discount [(6,421.50 – 3,000) × .10] $5,000.00 57 .

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Abnormal earnings Actual cash flow, 2005

$5,000,00

Expected cash flow, 2005 (4,000 × 0.30 + 3,000 × 0.50 + 5,000 × 0.20)

3,700.00

Expected cash flow 2006, at Dec. 31, 2005

5,000.00

Expected cash flow 2006, at Jan. 1, 2005

3,700.00

1,300.00

1,300.00 Present value at Dec. 31, 2005

1,300/1.10

Net income

1,181.80 $2,823.95

c. XYZ Ltd. Balance Sheet As at December 31, 2005

Financial Asset Cash (note 1)

Liabilities $3,288.02

Capital Asset, At present value

Bonds payable

$3,000.00

Shareholders’ Equity 4,545.45

Opening balance

3,421.50

Retained earnings (note 2) 1,411.97 4,833.47 $7,833.47 Notes:

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Cash = revenues (5,000.00) - interest expense (300.00) - dividends (1,411.98 (1/2 of net income of 2,823.95))

Retained earnings = net income (2,823.95) - dividends (1,411.98)

Present value-based financial statements under ideal conditions of

uncertainty are relevant because balance sheet values are based on expected future cash flows and dividend irrelevancy holds. They are reliable because present value calculations are representationally faithful. That is, since all states of nature are identified and have known, objective probabilities, the state realization is observable, and the economy-wide interest rate is known, present value calculations precisely represent asset and liability values, and cannot be biased by managers. e.

Investors are indifferent across dividend policies under ideal conditions

because cash retained and dividends distributed to investors earn the same known rate of return. Thus, regardless of the firms’ dividend policy, investors’ total wealth (the sum of dividends and value of share holdings in the firm) is independent of that dividend policy. Amounts not paid out as dividends remain within the firm and earn the same rate of return for the shareholders.

2A-2. a.

First, calculate the cost of the specialized machinery at 1 Jan., 2005: PA0 = 1/1.06[0.3 × 600 + 0.7 × 6000] + 1/(1.06)2[0.3 × 400 + 0.7 × 3000] = .9434[180 + 4200] + .8900[120 + 2100] = 4132.09 + 1975.80 = $6,107.89

Next, calculate the value of the machinery as at 1 Jan., 2006: PA1 = 1/1.06[0.3 × 400 + 0.7 × 3000] 59 .

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= .9434[120 + 2100] = $2,094.35 Relevant Ltd. Balance Sheet As at 31 December, 2005 Assets

Liabilities and Shareholders’ Equity

Cash (6,000-120)

$5,880.00

Capital Asset, at present value

2,094.35

Bank Loan

$2,000.00

Shareholders’ Equity Capital Stock $4,107.89 Retained Earnings 1,866.46

5,974.35

$7,974.35

Relevant Ltd. Income Statement For the Year Ended 31 December, 2005 Expected Net Income [6,107.89 – 2,000 × .06]

$246.46

Abnormal earnings Actual Cash Flow

6,000.00

Expected Cash Flow (600 × 0.3 + 6,000 × 0.7) Net Income

4,380.00

1,620.00 $1,866.46

Expected net income for 2006, evaluated as at 1 Jan., 2006 is: $5,974.35 × .06 = $358.46 60 .

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The financial statements are completely relevant because they are based

on the expected present value of future cash flows. Thus they give complete information to investors about the firm’s future economic prospects. They are completely reliable because the assumption of ideal conditions (essentially, that the set of possible states of nature, cash flows resulting from each state, and objective probabilities of the states, are publicly known) means that financial statement items are representationally faithful, free of bias, and verifiable.

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The discounted PV of the future income tax liability: At the end of year 1 PA1 =

1,800 2,520 5,112 3,168 − − − 1.12 1.12 2 1.12 3 1.12 4

= ($6,053.73) At the end of year 2 PA2 = −

2,520 5,112 3,168 − − 1.12 1.12 2 1.12 3

= ($8,580.17)

At the end of year 3 PA3 = −

5,112 3,168 − 1.12 1.12 2

= ($7,089.80)

At the end of year 4 PA4 = −

3,168 1.12

= ($2,828.57)

At the end of year 5 PA5 = 0 b.

It is because the balances calculated in part a are discounted to reflect

the PV of the future repayments of tax. This reduces their amounts.

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i) Repayment of the future income tax liability is triggered when capital

cost allowance falls below book amortization. Depending on the rate and time pattern of the growth of capital assets, the future income tax liability may never have to be actually repaid or, at least, the repayment could be postponed indefinitely. This would happen if the pool of capital assets grows sufficiently each year that capital cost allowance is always greater than straight-line amortization. ii) It is not clear what interest rate should be used for the discounting. A risk-free rate, the firm’s borrowing rate, or cost of capital are possible alternatives. iii) Under the liability view of income tax timing differences, the future income tax liability has to be adjusted for changes in the tax rate. Thus, for a completely relevant present value calculation, changes in tax rates, and the timing of such changes, would need to be anticipated. Lacking such anticipation, the future income tax liability would have to be adjusted as tax rates change. This would require considerable cost and effort, and would introduce volatility into reported net income. 2A-4. a.

PV of future net cash flows, January 1, 2005 Less net sales during 2005

$1,500,000 600,000 900,000

Accretion of discount (10% of 1,500,000) PV December 31, 2005

150,000 $1,050,000

GAZ Ltd.

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Income Statement For the Year Ended December 31, 2005

Accretion of discount (1,500,000 × .10)

$150,000

b. GAZ Ltd. Balance Sheet As at December 31, 2005

Financial Asset

Shareholders’ Equity

Cash (600,000 - 50,000) $550,000

Opening balance

$1,500,000

Capital Asset Reserves, at estimated P.V.

Retained earnings 1,050,000

(150,000 - 50,000)

$1,600,000

100,000 $1,600,000

Weaknesses of RRA:

•

The mandated discount rate of 10% might not reflect the actual risk and return for GAZ Ltd. This reduces relevance.

•

RRA involves making a large number of assumptions and estimates, with respect to quantities and timing of their extraction. As a result, estimated future RRA cash flows may bear little relationship to the net revenue the company will receive in the future. This reduces relevance.

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Frequent, material changes in estimates reduce the reliability of the RRA values.

•

RRA requires year-end oil and gas prices, rather than prices expected when it is anticipated the reserves will be lifted and sold. This reduces relevance (although, it increases reliability).

Use of a single 10% rate was mandated in SFAS 69 to improve

comparability across firms and over time for the same firm. The effect is to decrease relevance, since firms cannot choose a discount rate most suitable to their own riskiness and cost of capital. However, reliability is increased since management cannot bias the present value calculations by its choice of discount rate.

2A.5

Expected present value of asset on January 1, 2010 and 2011:

900   700  200 300  PA0 = 0.3 + + 0.7  + 2  2 1.06 1.06  1.06 1.06  = 0.3(660.38 + 801.00 ) + 0.7(188.68 + 267.00 ) = 0.3 × 1,461.38 + 0.7 × 455.68 = 438.41 + 318.98 = 757.39

900 300 + 0.7 × 1.06 1.06 = 0.3 × 849.06 + 0.7 × 283.02

PA1 = 0.3 ×

= 254.72 + 198.11 = 452.83 Rainy Ltd. Balance sheet As at December 31, 2010 65 .

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$650.00

Instructor’s Solutions Manual Chapter 2 Shareholders’ equity

Capital asset, at

Capital stock (PA1)

present value

$757.39

452.83

Retained earnings (395.44 – 50) 345.44

$1,102.83

Rainy Ltd. Income Statement For the year ended December 31, 2010

Expected net income (accretion of discount) (757.39 × .06)

$45.44

Abnormal earnings Expected cash flow (0.3 × 700) + (0.7 × 200) = (210 + 140) $350.00 Actual cash flow

700.00

Net income for the year

350.00 $395.44

The main reason why the present value calculations may become

unreliable is that objective state probabilities are not available. Consequently, subjective probabilities must be assessed. However, these are subject to error and bias. Consequently, they are low in reliability. Other reasons include the lack of a single interest rate in the economy, identifying the set of states of nature, and possible non-observability of the state realization. All of these introduce additional sources of error and bias into the present value calculations, reducing reliability.

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A main reason is incomplete markets. Then, income cannot be measured

by the change in the market values of the firm’s assets and liabilities. Lacking complete markets, fair value estimates or discounted present values must be used to value assets and liabilities. However, such estimates and calculations are low in reliability, resulting in major adjustments to previous years’ estimates. If true net income existed, there would be no adjustments. In view of these problems, accountants have retained historical cost for major asset and liability classes and adopted criteria of decision usefulness and full disclosure.

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CHAPTER 3 THE DECISION USEFULNESS APPROACH TO FINANCIAL REPORTING 3.1

Overview

3.2

The Decision Usefulness Approach 3.2.1 Summary

3.3

Single-Person Decision Theory 3.3.1 Decision Theory Applied 3.3.2 The Information System 3.3.3 Information Defined 3.3.4 Summary

3.4

The Rational, Risk-Averse Investor

3.5

The Principle of Portfolio Diversification 3.5.1 Summary

3.6

Increasing the Usefulness of Financial Reporting 3.6.1 Introduction 3.6.2 Objectives of Management Discussion and Analysis 3.6.3 An Example of MD&A Disclosure 3.6.4 Is MD&A Decision useful? 3.6.5 Conclusion

3.7

The Reaction of Professional Accounting Bodies to the Decision Usefulness Approach 3.7.1 The Conceptual framework 68 .

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3.7.2 Summary 3.8

Conclusions on Decision Usefulness

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

Decision Usefulness

The main purpose of this Chapter is to provide a framework for understanding the concept of decision usefulness of financial reporting. Consistent with the conceptual framework, I assume that the major decision problem to which financial reporting is oriented is the investment decision. I then argue that if accountants are to produce financial statements that are useful for investment decisions, they need to understand how rational investors make such decisions. 2.

Single-person Decision Theory

I use this theory, including the revision of beliefs by means of Bayes’ theorem, as a model of rational investment decision making. Prior to getting into the theory itself, I usually discuss with the class how they would proceed to make investment decisions if they had a sum of money to invest, and steer the discussion to make the point that single-person decision theory provides a systematic and formal way to do what many of them would do anyway. Some instructors and students may disagree with this argument, in view of increasing acceptance by academics that securities markets are not fully efficient, and that investors may not be rational in an economic sense. These issues are discussed in Section 6.2. I argue there that securities markets are sufficiently close to full efficiency that the efficient markets model is still the most useful one to use for studying the information needs of investors, and that if some of the underlying assumptions of many economic models are relaxed, the rational investment decision model can explain security price behaviour that is often attributed to non-rational investor behaviour. I also argue that to the extent securities markets are less than fully efficient, the scope for decision useful information is increased.

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I stick quite close to the text when illustrating the decision theory model, since this model and the concepts that go into it are new to most students. I go over in detail either the text example or some other similar example such as one of the end-ofchapter problems. I always end up by asking the class how realistic they think the model is (see point 4 below for additional discussion). If a student is particularly critical, I fall back on asking again how he or she would make an investment decision under similar circumstances. I do not particularly try to defend the extent to which the model can be operationalized. However, as stated above, I do make the argument that whether it is operational or not, it is a very useful conceptual device to help us understand what information is and how investors may find financial statement information to be useful. It is important to emphasize that the decision theory model is a model of an average investor. There is no implication that all investors act this way. The real question is whether investors on average behave as the model predicts or whether on average they are biased away from the model’s predictions. 3.

The Concept of an Information System

This is one of the most important concepts in the text. While the idea of the financial statements being represented as a table of objective, conditional probabilities may take some getting used to, the information system provides the crucial link between current reported performance and the future performance of the firm. It conceptualizes the quality of the financial statements with respect to their usefulness for investment decisions. Many reporting issues can be conceptualized by their effect on the main diagonal probabilities of the information system. For example, a switch from historical cost to current value accounting, or earlier recognition of revenue, increases these probabilities by increasing relevance. This tightens up the relationship between current and future performance and, other things equal, increases decision usefulness. However, to the extent that fair value accounting and early revenue recognition are less reliable than historical cost, this would have the opposite effect on the main diagonal probabilities. 70 .

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The net effect on decision usefulness is thus not clear, but the information system is helpful in conceptualizing the nature of the trade-offs in accounting policy choice and the concept of earnings quality--higher main diagonal probabilities, higher quality. There are numerous ways of measuring earnings quality empirically, such as analyst forecast revisions, market response to net income, accruals. All of them can be tied back conceptually to the main diagonal probabilities. I find that the students’ understanding of the information system is helped if the instructor spends some time on the two extremes — a perfect system and a useless system. See Problem 1 of this chapter. This problem pushes understanding by showing what happens when state probabilities are revised by Bayes’ theorem using the conditional probabilities from the perfect and from the useless information systems. I have structured the states of nature in Example 3.1 in terms of future firm performance, rather than some more primitive states such as good economy or bad economy. Future firm performance can be conceptualized in terms of future cash flows, earnings, or dividends Many discussions and models of firm performance and value are based on expected future dividends or cash flows, particularly in the finance literature. I include future earnings as an alternate measure of performance and value to be consistent with Ohlson’s Clean Surplus Theory, which is discussed in Section 6.10. The Ohlson theory shows that the market value of the firm can equally be expressed in terms of expected future dividends, cash flows or financial statement variables. Since this is an accounting text, it seems natural to take financial statement variables such as earnings as a fundamental determinant of firm performance and value, on an equal footing with cash flows and dividends. Also, the Ohlson theory and modifications and extensions of it, have become quite common in empirical accounting research and in accounting practice. Empirical implications of clean surplus theory are discussed and illustrated in Section 6.10.4.

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Does it Work?

While, as stated above, I do not particularly try to defend the decision theory model as an operational way to make decisions, I do spend some time discussing with the class whether they would be willing to make an investment decision this way. The following notes, which could be distributed to the students, discuss some of the issues in applying the procedure. Issues in Applying the Decision Theory Model Specifying the states of nature. States of nature are specific to the decision problem at hand. For example, if my decision is whether or not to take my raincoat, relevant states would be rain or no rain. That is, the relevant states of nature are simply those random events whose outcome matters to the decision at hand. In an investment context, these can be taken as different levels of future firm performance, since it is future performance that determines investment payoff. Specifying prior probabilities of the states of nature. These capture everything the decision maker knows up to the beginning of the decision analysis. There are techniques to help specify these probabilities. One technique is to conceptualize an urn containing 100 coloured balls, of which a certain number are red and the remainder black. To illustrate, suppose an investor wants to assess his/her prior probability of high future firm performance next year. Envisage a bet of, say, $50 on this state—if future performance is high you win $50, otherwise you lose $50. Now consider another bet. You will draw 1 ball from the (opaque) urn. If you draw a red ball you win $50, otherwise you lose $50. How many red balls should there be in the urn so that you are indifferent between the 2 bets? Suppose you decide you would be indifferent if the urn contains 6 red balls. Then, your subjective probability of high future firm performance is 0.06. Since prior probabilities are subjective, we cannot say that this probability is “correct.” The point is, however, that in deciding on the number of red balls you are forced to consider everything you know about the firm’s future prospects. 72 .

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Specifying payoffs. For each state of nature, specification of your payoff if a particular state happens should be relatively straightforward. For example, suppose you invest $10,000 in shares of X Ltd. and the high performance state happens. Analysis of past share price behaviour of X Ltd. when the firm is performing well may reveal an average share return of 16%, that is, a net payoff of $1,600. Of course, if you decide to invest your $10,000 in a riskless asset instead, the states of nature for X Ltd. do not affect your payoff—if you buy a government bond yielding 21/4%, your payoff will be $225 regardless of X’s performance. That is, states of nature only apply to decisions with uncertain payoffs. Nevertheless, in deciding between a risky and a riskless investment, you need to evaluate the payoff from the risky asset even if your decision turns out to be to buy the riskless one. In other cases, your decision may be between 2 or more risky investments. Specifying your utility function. Since most decision makers are risk averse, the expected utility of a risky payoff depends on how risky it is. The text uses the device of a utility function to calculate expected utility. There are techniques available to interrogate yourself to estimate your utility function. A related approach is to estimate your expected utility for a given risky investment directly. For example, suppose you intend to invest $10,000 and are considering a risky gamble of a 0.30 probability of a payoff of $1,600 and a 0.70 probability of a payoff of zero. Ask yourself, what certain payoff would you need to be indifferent between this payoff and the risky gamble just described? Suppose you feel the certain payoff is $200. Then, you could use $200 (called a certainty equivalent) as your expected utility for the risky gamble. If an alternative investment yields a certainty equivalent of, say, $225, you would take the alternative. Note that a riskless investment is an alternative, such as a government bond (of a financially secure country), yielding a return of $225, you could take the $225 payoff as your certainty equivalent for this investment. Versions of this approach are used by investment advisors, who ask clients whether their tolerance for risk is low, medium, or high. This helps them evaluate the client’s 73 .

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certainty equivalents for investments of differing risks. Thus, if a client has high risk tolerance, his/her certainty equivalent for the above gamble might be $250. Then, the advisor would advise a risky gamble, whereas a lower-risk gamble would be advised for a low risk tolerance investor. The information system. If you decide to gather more information before acting, specification of the information system is a difficult aspect of your decision problem. Unlike prior probabilities, information system probabilities are objective. If your additional evidence is to be obtained from financial statements, the information system probabilities are determined by the quality of GAAP. Thus, if X Ltd. is in the high performance state, the probability that the financial statements show GN will be higher the higher is the quality of GAAP. Nevertheless, it is still possible that the financial statements show BN since GAAP cannot completely rule out errors and biases in accounting estimates. However, the information system probabilities are also affected by the integrity of the manager, who may, within GAAP, or even in violation of GAAP, manage the financial statements opportunistically. Thus the probabilities also depend on the quality of the firm’s corporate governance. In this regard, see Note 8 of this Chapter. One approach to estimating information system probabilities is to use a sampling approach to analyze the past relationship between financial statements and subsequent firm performance. When past financial statements have shown GN, how many times has next year’s firm performance been high, etc.? Another approach is to estimate information system probabilities based on analyst reaction to the financial statements, as outlined in Section 3.3.2 of the text. The stronger is analyst reaction per dollar of GN or BN, the higher the information system main diagonal probabilities. Conclusion. You may feel that there are so many issues surrounding the inputs into the decision theory model that the procedure is not viable. If so, ask yourself how else you would make a decision under uncertainty. By forcing careful consideration of the

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variables that really matter to a decision, the decision theory approach may well lead to better decision making on average. Of course, you may instead turn your decision making over to an expert, such as a financial institution or advisor. However, if you do, you still face a decision problem-which financial advisor, how much to invest, do you accept the advisor’s advice, etc. The issues described above still apply. Finally, whether or not you accept the model, a major argument of Chapter 3 is that the model reasonably captures the behaviour of the average investor, even though individual investors may not follow the procedures exactly. As such, the model provides guidance to accountants about the information needs of investors and the crucial role of information in facilitating these decisions. 5.

Portfolio Theory and the Optimal Individual Investment Decision

The text then goes on to the principle of portfolio diversification, since an understanding of diversification is crucial to understanding many of the empirical and theoretical discussions later in the text. Note: The following is a more complete illustration and explanation of the theory of the optimal investment decision than that given in Sections 3.5 and 4.5 of the text. It was included in earlier editions of the text, and is reproduced here for instructors who may wish to consider this theory more thoroughly. The Principle of Portfolio Diversification In Section 3.4, we stated that individual investors are typically assumed to be riskaverse. Consequently, for a given expected payoff from investments the rational investor wants the lowest possible risk or, equivalently, for a given risk, will want the highest possible expected payoff. In effect, the investor adopts a trade-off between risk and return; greater risk will be borne only if expected return is higher and vice versa.

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One way investors can lower risk for a given expected return is to adopt a strategy of diversification, that is, to invest in a portfolio of securities. The principle of portfolio diversification shows us that some, but not all, risk can be eliminated by appropriate investment strategy. This principle has important implications for the nature of the risk information that investors need. The risk reported on by many common accountingbased risk measures, such as debt to equity, times interest earned (ratio of net income before interest and taxes to interest expense), or the current ratio, can be reduced or eliminated a priori by appropriate diversification. Before illustrating the diversification principle, we return briefly to our risk-averse investor. Note that before we can calculate an individual’s expected utility for different investment acts, we need to know what that individual’s utility function looks like. For example, Bill Cautious’ utility function in Example 3.1 was U(x) = √𝑥 , x ≥ 0. With this utility function and payoff probabilities, Bill’s expected utilities for different acts were calculated and compared. One might reasonably ask, “How do we know what an individual’s utility function is?” To avoid this question, we shall now assume mean-variance utility, which provides a model utility function of a typical risk-averse investor: 𝑈𝑖 (𝑓𝑖 ) = 𝑓𝑖 (𝑥̅𝑎 , 𝜎𝑎2 )

where symbol a represents an investment act. For example, investment act a could be an investment in a riskless government bond, or in a firm’s shares, as in Example 3.1. Alternatively, it could be an investment in a portfolio of securities. The equation states that the utility of an investment act a to investor i is a function fi of the expected rate of return from that act 𝑥̅ a and the risk as measured by its variance σa2.

We assume that fi is increasing in 𝑥̅ a and, to capture risk aversion, decreasing in σa2. A

specific example of a mean variance utility function is: 𝑈𝑖 (a)= 2𝑥̅ ɑ - 𝜎𝑎2

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which can be seen to increase in 𝑥̅ɑ and decrease in σɑ2. Individuals will have different trade-offs between expected rate of return and risk—for example, a more risk-averse

investor might have –2σɑ2 rather than –σɑ2 as shown above. It is not true in general that the utility of an act depends only on its mean and variance. However, investigation of this is beyond our scope. The significance of a mean-variance utility assumption to accountants is that it makes investors’ decision needs more explicit—all risk averse investors need information about the expected values and riskiness of returns from investments, regardless of the specific forms of their utility functions. Without such an assumption, specific knowledge of investors’ utility functions would be needed to fully deduce their information requirements. With this background in mind, we now illustrate the principle of portfolio diversification by means of two examples. Suppose that Toni Difelice, a risk-averse investor has $200 to invest and is considering investing all of it in the shares of firm A, currently trading for $20. Assume that Toni assesses a 0.74 probability1 that the shares will increase in market value to $22 over the coming period and a 0.26 probability that they will decrease to $17. Assume also that A will pay a dividend of $1 per share at the end of the period (we could also make the dividend uncertain, but this would just add complexity without affecting the point to be made). Example 3.2 The Principle of Portfolio Diversification (Part 1) As in our decision theory Example 3.1, Toni’s subjective probabilities could be posterior to her analysis of firm A’s financial statements and the resulting application of Bayes’ theorem. Alternatively, they could be her prior probabilities based on whatever other information is at her disposal. For present purposes, the extent to which Toni may have 77 .

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become informed does not matter. The important point is that she has assessed probabilities. The gross payoffs from Toni’s proposed investment are as follows: If shares increase: $22 × 10 shares + $10 dividend = $230 If shares decrease: $17 × 10 shares + $10 dividend = $180 Table 3.3 shows the calculation of the expected rate of return and variance of this investment. Henceforth, we will work with the rate of return. As can be seen from Table 3.3, this just involves dividing net returns by the amount of original investment ($200). The division by original investment is a standardization device—rates of return can be directly compared across securities while amounts of returns cannot. Also, rate of return fits in nicely with the assumption of mean-variance utility, which is in terms of the expected value and variance of rate of return. Table 3.3 Calculating Expected Rate of Return and Variance Expected Payoff Rate of Return $230

230−200

$180

180−200

200

= 0.15

Probability Rate of Return

= −0.10

Variance (0.15 - .0850)2 × 0.74 = 0.0031

0.74

0.1110

0.26

- 0.0260 (-0.10 – 0.0850)2 × 0.26 = 0.0089 𝑥̅ a = 0.0850

𝜎𝑎2 = 0.0120

The variance of return is 0.0120. The variance of an investment return serves as a

measure of its riskiness. Since Toni is risk-averse, increasing riskiness will lower her utility, other things equal. Assume that Toni’s utility function is: 78 .

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𝑈𝑖 (a)= 2𝑥̅ɑ - 𝜎𝑎2

as given above. Then, her utility for this investment is: (2 × 0.0850) – 0.0120 = 0.1580 Toni now has to decide whether to take this investment act. If she feels that this utility is not sufficiently high, further research would be necessary to find a more attractive investment, or some other use for the $200 of capital. Example 3.3 The Principle of Portfolio Diversification (Part 2) It turns out that Toni would not be rational to accept the above investment—a more attractive investment can be found. It is possible to find another investment decision that has the same expected return but lower risk. This is because of the principle of portfolio diversification. To illustrate, assume that shares of firm B are also traded on the market, with a current market value of $10. These shares also pay a dividend of $1. Assume there is a 0.6750 probability that firm B’s shares will increase in market value to $10.50 at the end of the period, and a 0.3250 probability that they will decrease to $8.50. Now suppose that Toni decides to invest $200 in six shares of firm A at $20 and eight shares of firm B at $10. We must calculate Toni’s expected utility for the portfolio consisting of six shares of firm A and eight shares of firm B. Notice that the same amount ($200) is invested, but that it is now spread over two different securities. Four possible payoffs now exist from the portfolio: both shares increase in market value, one share increases and the other decreases, or both shares decrease. The amounts of the payoffs and their assumed probabilities are as follows in Table 3.4:

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Table 3.4 Payoffs and Their Probabilities A

Dividends

Total Payoff

Probability

132

$230

0.5742

132

$214

0.1658

102

$200

0.1008

102

$184

0.1592 1.0000

Recall that six shares of firm A and eight shares of firm B are held, and that the high gross payoff is $22 per share for firm A and $10.50 for firm B, plus a $1 dividend from each share. This gives the $230 payoff on the first line of the table. The other payoffs are similarly calculated. Now let us consider more closely the probabilities we have assumed for the four possible payoffs. The returns from shares of firm A and firm B are correlated in our example. To see this, consider the first row in Table 3.4 with a total payoff of $230. This payoff will be realized if both shares A and B realize their high-payoff values. On the basis of our assumption about the probabilities of the individual payoffs of shares A and B, the probabilities of these two payoffs, when each share is considered separately, are 0.74 for A and 0.6750 for B. If the payoffs of shares A and B were independent, the probability of both shares realizing their high payoffs would be 0.74 × 0.6750 = 0.4995. However, in any economy, there are states of nature, also called factors, which affect the returns of all shares, such as levels of interest rates, foreign exchange rates, the level of economic activity, and so on. These are called market-wide or economy-wide factors. Their presence means that if the return on one share is high, it is more likely that the returns on most other shares in the economy will also be high—more likely, that is, than would be the case if the returns on shares were independent. Thus, we have assumed that the probability that both shares A and B realize their high payoffs is 80 .

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0.5742, which is greater than the 0.4995 that we would obtain under independence, to reflect these underlying common factors. Similar reasoning applies to the last row of Table 3.4 with a payoff of $184. Here we have assumed that the joint probability of both firm A and firm B realizing their low payoffs is 0.1592, greater than the (0.26 × 0.3250 = 0.0845) probability under independence. If market-wide state realizations are such that they work against high returns (i.e., if the economy is performing poorly), then the probability that both shares realize low payoffs is greater than what would be expected under independence. Table 3.5 Calculating Expected Rate of Return and Variance Expected Payoff Rate of Return Probability Rate of Return $230

230−200

$214

214−200

$200

200−200

$184

184−200

[

200

200 200

200

Variance

= 0.15

0.5742

0.0861

(0.15 – 0.0850)2 × 0.5742 = 0.0024

= 0.07

0.1658

0.0116

(0.07 – 0.0850)2 × 0.1658 = 0.0000

= 0.00

0.1008

0.0000

(0.00 – 0.0850)2 × 0.1008 = 0.0007

= −0.08

0.1592

-0.0127

(-0.08 – 0.0850)2 × 0.1592= 0.0043

𝑥̅ a = 0.0850

σ2a = 0.0074

Of course, while share returns may be correlated due to common factors, they will not be perfectly correlated. It is still possible that one firm realizes a high return and another a low return—witness the two middle rows of Table 3.4. This is because, in addition to economy-wide factors, there are also firm-specific factors, also called idiosyncratic factors, that affect the return of one firm only. Examples include the quality of a firm’s management, new patents, strikes, machine breakdowns, and so on. Thus, the second row of the table represents a situation where firm A realizes a high return (say, because of a new invention it has just patented) and firm B realizes a low return (say, because of 81 .

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a critical machine failure in its assembly line). However, due to the presence of economy-wide factors, the probabilities for these high/low payoff realizations will also be different than under independence. This is true of Example 3.3. Thus, if all factors were economy-wide, returns on firms’ shares would be perfectly correlated. If all factors were firm-specific, returns would be independent. As is usually the case, the truth lies somewhere in between. Consequently, the probabilities given in Table 3.4 assume that both types of factors are present.2 The expected rate of return and variance of Toni’s portfolio of A and B shares are calculated in Table 3.5 using the correlated probabilities. Thus, the expected rate of return of the portfolio is 0.0850, as before (we have forced this result by appropriate choice of the probabilities, to facilitate comparison), but the variance has decreased to 0.0074, from 0.0120. Since Toni is risk-averse, she would be better off buying the portfolio of A and B shares rather than just A, because the expected return is the same, but the risk is lower. In fact, her utility now is: Ui(ɑ) = (2 × 0.0850) – 0.0074 = 0.1626 up from 0.1580 for the single-share investment. 3.5.1 Summary Risk-averse investors can take advantage of the principle of portfolio diversification to reduce their risk, by investing in a portfolio of securities. This is because realizations of firm-specific states of nature tend to cancel out across securities, leaving economy-wide factors as the main contributors to portfolio risk.

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While individual attitudes to risk may differ, we can see investors’ decision needs with particular clarity if we assume mean-variance utility. Then, regardless of the degree of risk aversion, we know that utility increases in expected rate of return and decreases in variance of the portfolio. 3.6 The Optimal Investment Decision If a portfolio of two shares is better than one, then a three-share portfolio should be better than two, and so on. Indeed, this is the case and, assuming there are no transaction costs such as brokerage fees, Toni should continue buying until the portfolio includes some of every security traded on the market. This is called “holding the market portfolio.” Note again that the total amount invested remains at $200, but is spread over a greater number of securities. Be sure you understand why the same amount invested in a portfolio can yield lower risk than if it were invested in a single firm for the same expected rate of return. To repeat, when more than one risky investment is held, the firm-specific risks tend to cancel out. If one share realizes a low return, there is always the chance that another share will realize a high return. The larger the number of different firms’ shares in the portfolio, the more this effect can operate. As a result, the riskiness of returns is reduced, which we have illustrated above by means of our variance calculations. Of course, in the presence of economy-wide risk, there is not a complete cancelling out. At a minimum, that is, when the market portfolio is held, the economy-wide factors will remain to contribute to portfolio risk. Such non-diversifiable risk is called systematic risk.3 Conceptually, the market portfolio includes all assets available for investment in the economy. As a practical matter, the market portfolio is usually taken as all the securities traded on a major stock exchange. The return on the market portfolio can then be proxied by the return on a market index for that exchange, such as the Dow Jones Industrial Average index of the New York Stock Exchange, the S&P/TSX Composite Index, etc. 83 .

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Now return to our investor, Toni Difelice. Toni decides to buy the market portfolio after hearing about the benefits of diversification. Her first task is to assess the expected return and variance of the market portfolio. She subjectively assesses a 0.8 probability that the S&P/TSX Composite Index will increase by 10% for the coming period and a 0.2 probability that it will increase by 2 1/2%. Then, denoting the expected return and variance of the market portfolio by x M and σM2 respectively: 𝑥̅ M = (0.10 × 0.8) + (0.0250 × 0.2) = 0.0850

σ2M = [(0.10 – 0.0850)2 × 0.8] + [(0.0250 – 0.0850)2 × 0.2] = 0.0002 + 0.0007 = 0.0009

This gives Toni a utility of: 2𝑥̅ M – σ2M = 0.1700 – 0.0009 = 0.1691

which is greater than the 0.1626 utility of the two-share portfolio in Example 3.3. The question now is: Is this Toni’s optimal investment decision? The answer is probably not. If Toni were quite risk-averse, she might prefer a portfolio with lower risk than 0.0009, and would be willing to have a lower expected return as a result. One strategy she might follow would be to sell some of the high-risk stocks in her portfolio. But, if she does this, she is no longer holding the market portfolio, so some of the benefits of diversification are lost. How can Toni adjust portfolio risk to her desired level without losing the benefits of diversification? The answer lies in the risk-free asset. If a risk-free asset, such as treasury bills yielding, say, 4%, is available, an investor could sell some of the market portfolio (that 84 .

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is, sell some of each security, so that the market portfolio is still held but total investment in it is lower) and use the proceeds to buy the risk-free asset. Conversely, if Toni were less risk-averse, she may prefer to borrow at the risk-free rate and buy more of the market portfolio, thereby moving to higher expected return and risk. In this way, each investor can secure a desired risk–return trade-off while continuing to enjoy the maximum risk-reduction effects of diversification. To illustrate, suppose that Toni borrows $100 at a rate of 0.04 and buys an additional $100 of the market portfolio. Toni now has $300 of market portfolio, on which she expects to earn 0.0850, and owes $100 at 4% interest. But her own investment is still $200. Consequently, her expected return is now: 𝑥̅ ɑ = (300/200 × 0.0850) – (100/200 × 0.0400) = 0.1275 – 0.0200 = 0.1075 The variance of her return also increases, since she now has $300 at risk on an investment of $200. There is no variance attached to the $100 borrowed, of course, since interest and principal payments are fixed. The variance of her return is now: σ2ɑ = (300/200)2 × 0.0009) = 0.0020 yielding utility of (2 × 0.1075) – 0.0020 = 0.2130. This yields Toni a higher utility than simply holding the market portfolio (0.1691). Toni will continue to borrow until the amount borrowed and reinvested yields an x a and σɑ2 that maximizes her utility. In fact, if she can borrow all she wants at 4%, she would borrow $9,800, which would yield her utility of 2.33. 3.6.1 Summary 85 .

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When transaction costs are ignored, a risk-averse investor’s optimal investment decision is to buy that combination of market portfolio and risk-free asset that yields the best trade-off between expected return and risk. This trade-off is individual-specific—it depends on the investor’s utility function. Some investors may wish to reduce their investment in the market portfolio and buy the risk-free asset with the proceeds. Others may wish to borrow at the risk-free rate and increase their investment. Either way, all investors can enjoy the full benefits of diversification while at the same time attaining their optimal risk–return trade-off. 3.7 Portfolio Risk 3.7.1 Calculating and Interpreting Beta The principle of diversification leads to an important risk measure of a security in the theory of investment. This is beta, which measures the co-movement between changes in the price of a security and changes in the market value of the market portfolio. To illustrate, we will calculate the betas of shares of firms A and B in Example 3.3, in relation to the market portfolio M given in Section 3.6. Beta is an important and useful concept in financial accounting. As we shall see in Chapter 5, a stock’s beta is a crucial component of empirical studies of the usefulness to investors of financial accounting information. Also, it is a “launching pad” for reporting on firm risk. Consequently, an understanding of what a stock’s beta is and what it tells us about firm risk is an important part of an accountant’s knowledge base. Example 3.4 Calculating Beta The beta of A shares, denoted by βA , is given by: βA =

𝐶𝑜𝑣(𝐴,𝑀) 𝑉𝑎𝑟(𝑀)

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where Cov(A,M) is the covariance of the returns on security A with the returns on the market portfolio M. In effect, βA measures how strongly the return on A varies as the market varies. For example, a high-beta security would undergo wide swings in its rate of return as market conditions change. Shares of airlines and aircraft manufacturers are examples, since these industries are sensitive to economic conditions. Shares of electric utilities and fast food firms would be low-beta, since the returns of such firms are less subject to the state of the economy. Division by Var(M) is simply a standardization device, to express Cov(A,M) in units of market variance. For example, if the returns on the Toronto and New York Stock Exchanges have different variances, standardization by the variance of returns on the respective exchanges makes betas of Canadian and U.S. firms more comparable. To calculate the beta of security A, assume that the conditional payoff probabilities of security A are as follows: ■

When return on M is high: Probability that return on A is high = 0.90 Probability that return on A is low = 0.10

■

When return on M is low: Probability that return on A is high = 0.10 Probability that return on A is low = 0.90

These probabilities could be estimated by examining past data on the returns on A shares in relation to the returns on M. Cov(A,M) is calculated in Table 3.6. Table 3.6 Calculation of Covariance Returns

Joint 87 .

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Probabilities

High High

(0.15 – 0.0850) × (0.10 – 0.0850) × 0.72 = 0.0007

High Low

(0.15 – 0.0850) × (0.0250 – 0.0850) × 0.02 = -0.0001

Low

High

(-0.10 – 0.0850 × (0.10 - =0.0850 × 0.08 = -0.0002

Low

(-0.10 – 0.0850) × (0.0250 – 0.0850) × 0.18) = 0.0020 Cov(A,M) = 0.0024

In the first row of the table, the values 0.15 and 0.0850 are the high return and the expected return respectively of A (see Table 3.3). Similarly 0.10 and 0.0850 are the high return and the expected return of M (see Section 3.6). The joint probability that both A and M pay off high is: Prob(A high and M high) = Prob(M high) Prob(A high|M high) = 0.8 x 0.9 = 0.72 You should verify the remaining rows in the table. Then, recalling from Section 3.6 that σ2M = Var(M) = 0.0009, we obtain:

𝛽𝐴 =

0.0024

0.0009

= 2.6667

For security B in Example 3.3, assume that the conditional payoff probabilities are: ■

When return on M is high: Probability that return on B is high = 0.7917 Probability that return on B is low = 0.2083

■

When return on M is low: 88 .

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Probability that return on B is high = 0.2083 Probability that return on B is low = 0.7917 Then, similar calculations give:

𝛽𝐵 =

0.0014

0.0009

= 1.5556

You should verify this calculation.4 Since βB is lower than βA, an investor who buys only B shares is more insulated from the ups and downs of the stock market than if he/she buys only A shares. This is the sense in which a low-beta security has low risk.5 3.7.4 Summary If we ignore the transactions costs of buying securities, the optimal investment decision is to buy all securities available on the market, thereby obtaining maximum diversification. The risk-averse investor’s desired risk/return trade-off can then be attained by borrowing to buy the risk free asset, which increases expected return and risk to the desired level. Conversely, risk can be reduced by selling a portion of the market portfolio and investing the proceeds in the risk free asset. When transactions costs are not ignored, this policy would be too costly. Then, the riskaverse investor’s optimal investment decision is to buy fewer securities, rather than the whole market portfolio. In this way, some of the benefits of diversification can be attained, at reasonable cost. Information about securities’ expected returns and betas is useful to such investors. This enables them to assess the expected return and riskiness of various portfolios that they may be considering. They can then choose the portfolio that gives them their most preferred risk–return trade-off, subject to the level of transactions costs that they are willing to bear. Notes 89 .

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We have suppressed the set of states of nature in this example. That is, Toni

assesses payoff probabilities directly, rather than routing them through states. Thus, instead of saying “The probability that firm A is in high-performance state is 0.74 and if A really is in this state the payoff will be $230,” we simply say “The probability of the $230 payoff is 0.74.” This simplification has certain analytical advantages and is frequently used. 2.

This argument assumes that the only source of correlation between returns on

firms’ shares is market-wide factors. In effect, we have partitioned states of nature that can affect share returns into two components—economy-wide and firm-specific. This is a simplification, since, for example, industry-wide factors could introduce additional returns correlation. However, the simplification is a widely used one and is sufficient for our purposes. It leads to an important measure of share riskiness (beta), which we will discuss shortly. 3.

The risk we are referring to here is ex ante risk. That is, the investor is in the

process of an investment decision and is looking ahead. This is not to say that if a firm in the portfolio realizes, say, a low return because some unfortunate firm-specific risk factor has happened, the investor will not be angry at that firm ex post. 4.

The expected return of B is �0.6750 ×

92−80 60

� + �0.3250 ×

76−80 80

�

= (0.6750 × 0.15) + (0.3250 × 20.05) = 0.0850 (See Example 3.3.) Cov(B,M) is calculated as Returns B M

Joint Probabilities

High High

(0.15 – 0.085) × (0.10 – 0.085) × 0.6333 = 0.0006

High Low

(0.15 – 0.085) × (0.025 – 0.085) × 0.0417 = 0.0002 90 .

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Low

High

(–0.05 – 0.085) × (0.10 – 0.085) × 0.1667 = 0.0003

Low

(–0.05 – 0.085 × (0.025 – 0.085) × 0.1583 = 0.0013 Cov(B,M)

= 0.0014

The joint probability of B high and M high is given by 0.8 × 0.7917 = 0.6333. You should now verify the remaining lines. 5. Note that A shares have the same expected return as B shares (0.085), but higher risk since βA = 2.6667 while βB = 1.5556. Then, it might seem that Toni should buy only B shares. However, this is not the case—Toni will still want to hold both A and B shares in her portfolio. If she invests all of her $200 in B, it can be shown that her expected return is 0.085 and variance of return is 0.0088, giving expected utility of 0.1612, which is less than expected utility of 0.1626 from holding both A and B. In this case, the benefits of diversification outweigh the fact that B shares by themselves have lower risk. 6.

MD&A

I feel it is important to bring the students back to some specific financial reporting issues to show how accountants are grappling with the full disclosure implications of decision usefulness, particularly reporting on firm risk. For this purpose, I use MD&A. I usually hand out an example of at least the risks and uncertainties and future-oriented sections of MD&A from a current annual report, or ask the students to choose an annual report, and assign a critique of its MD&A disclosure, using the example in the chapter as a template. Discussion of the information content of the MD&A often reveals a tendency for firms to rehash information already available from other parts of the annual report, and to give only vague discussion, if any, of risks and uncertainties and future plans. I ask why some firms choose to give extensive and candid disclosure. Favourable impacts on cost of capital (see the discussion in Section 12.9) and even on product markets are possibilities. In this edition, I have added a section (Section 3.6.4) on the decision usefulness of MD&A. This research is relatively new. Coverage of this section is not essential. 91 .

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However, it may be of interest to students and instructors who wish to consider how sophisticated programs to evaluate the written word can be applied to a topic of interest to accountants. The study of Li (2010) can also be used to show an application of Bayesian decision theory considered in this chapter. In Theory in Practice 3.3 I have organized my outline of Li’s study to be consistent with the earlier decision theory development, particularly in how the information system can be derived. The study of Brown and Tucker (2011) is more straightforward. 6.

The Conceptual Framework

As a final step in motivating the decision theory, I outline Chapters 1 and 3 of the Conceptual Framework. In particular, I show how the theory shows up in the Framework, by discussing how it has “bought” the decision usefulness approach. The main difference from the decision theory model presented in the text is that the word ‘rational” does not appear as a specific investor characteristic. Possibly, this is because of the theory and evidence from behavioural finance that disputes rationality (although I have been told in correspondence by a member of the IASB at the time that it is hard to envisage non-rational decision making). Also, the Framework envisages the role of financial reporting as providing information to a wide variety of constituencies, not just to investors. Since “true” net income does not exist, and since different users have decision needs, it is not clear to me how a single set of financial statements can cater to different user constituencies. Nevertheless, the role of financial reporting as conveying useful information to decision makers comes through clearly in the Framework. The word “rational” was used in SFAC 1, being Chapter 1 of the original FASB conceptual framework. Some instructors may be interested in the route by which such an abstract theory as the theory of rational decision entered into the FASB concepts statements. The source appears to be the American Institute of Certified Public Accountants Study Group on the Objectives of Financial Statements, “Objectives of Financial Statements,” (New York, NY: AICPA, 1973), also known as the Trueblood 92 .

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Report. According to Zeff in his article “The Evolution of the Conceptual Framework for Business Enterprises in The United States,” (Accounting Historians Journal (December, 1999)), the Trueblood Report provided a “blueprint” for the FASB concepts statements. This can be seen with particular clarity in Volume 2: Selected Papers of the Trueblood Report, which contains several studies on the use of accounting information in normative models of investor consumption/investment decisions. See, in particular, Ronen, J., “A User Oriented Development of Accounting Information Requirements,” in J. J. Cramer and G. H. Sorter, editors., Objectives of Financial Statements: Volume 2 / Selected Papers (The Trueblood Report) (New York, NY: American Institute of Certified Public Accountants, 1974), pp. 80-103. Ronen, J. and G. H. Sorter, “The Descriptive and the Normative,” in J. J. Cramer and G. H. Sorter, editors., Objectives of Financial Statements: Volume 2 / Selected Papers (The Trueblood Report) (New York, NY: American Institute of Certified Public Accountants, 1974), pp. 24-29.

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

Perfect or Fully-Informative Information System Current Financial Statement Information GN State of nature (future profitability)

High

Low

Here, each state produces a different message with probability 1. Thus, if the state is H, the financial statements will show GN for certain, and so forth. Prior probabilities of the states of nature are: P(H) = 0.30 P(L) = 0.70 (any other set of prior probabilities with P(H) > 0 would do) Suppose that GN is observed. Then, by Bayes’ theorem: P ( H / GN ) =

P ( H ) P (GN / H ) P ( H ) P (GN / H ) + P ( L) P (GH / L) 0.30 × 1.00 = 1.00 (0.30 × 1.00) + (0.70 × 0)

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P ( L / GN ) =

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P ( L) P (GN / L) P ( H ) P (GN / H ) + P ( L) P (GN / L) 0.70 × 0 =0 (0.30 × 1.00) + (0.70 × 0)

Thus, with a perfect information system, the information perfectly reveals the true state of nature. If BN is observed, similar calculations give P(H/BN) = 0, P(L/BN) = 1. Non-Informative Information System Current Financial Statement Information GN

State of nature

High

0.8

0.2

(future profitability)

Low

0.8

0.2

Here, both rows of the information system are the same. Any system with both row probabilities the same would do. Note: Students have a tendency to use 0.5 probability in each row. This is OK, but instructors may wish to point out that other probabilities, such as those used above, also produce a non-informative system as long as the probabilities in each row are the same. More generally, the information system is noninformative if the row probability vectors are linearly dependent. Suppose that GN is observed. Then, by Bayes’ theorem:

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P( H / GN ) =

P( H ) P(GN / H ) P( H ) P(GN / H ) + P( L) P(GN / L)

0.30 × 0.80 = 0.30 (0.30 × 0.80) + (0.70 × 0.80)

P ( L / GN ) =

P ( L) P (GN / L) P ( H ) P (GN / H ) + P ( L) P (GN / L)

0.70 × 0.80 = 0.70 (0.30 × 0.80) + (0.70 × 0.80)

The posterior probabilities are the same as the prior probabilities in this case, which is what we would expect if the information system is non-informative. That is, regardless of which is the true state, the state probabilities are the same after the financial statements as before. In effect, the information cannot discriminate between states. Thus, it is non-informative, or useless. A similar result holds if BN is observed.

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The utility function of a risk-taking investor would appear as the solid line below:

U(x) 256

76.8

5.0625 0

225

x (payoff) 1,600 1,600

480

Compared with Figure 3.3, the utility function is convex, rather than concave. Thus, as the payoff x increases, utility increases at an increasing rate, rather than at a decreasing rate. A specific example of a risk-taking utility function is:

U ( x) =

x2 10,000

yielding the utilities shown on the vertical axis of the above figure. Consistent with Example 3.1, suppose a risky investment offers a payoff of $1,600 with probability 0.30 and $0 with probability 0.70, giving an expected return of $480. Our risk-taking investor's expected utility for this investment is 256 × 0.30 + 0 × 0.70 = 76.80. The utility of the risk free investment, which offers a 97 .

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payoff of $225 for sure, is only 5.0625. Thus, for the same prior probabilities and payoffs, the risk-taking investor prefers the risky investment whereas Bill Cautious, who is risk averse, prefers the risk-free investment. A risk-taking investor will specialize (that is, buy only one security) — the one with the highest risk for a given expected return. There is no incentive to diversify for an investor who likes risk. A risk-taking investor needs the same information as any other investor — information that will be useful in assessing expected returns and risks of securities. However, risk-taking investors will use the information differently. They will seek to find the securities that, for a given return, have the highest risk.

For a2 to yield the same utility as a1, we must have: 3 x a2 − 1 / 2σ x2

= 2.384

3 × 0.80 − 1 / 2σ x2 = 2.384

Solving for σ x2 :

1 / 2σ x2 = 2.400 − 2.384 = 0.016

σ x2

= 0.032

Thus act a2 would require σx2 of 0.032 to yield the same utility as act a1. A risk-averse investor trades off risk and expected return. An investment act with a lower expected return must also have lower risk if it is to give the same expected utility. As shown in the calculation, the risk of a2 (0.032) is less than

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that of a1 (0.512) in order to compensate for the reduction in expected return from 0.88 to 0.80.

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The argument is probably made because of the “lumpiness” of certain cash receipts and disbursements. Cash payments for major purchases such as capital assets, and for borrowings such as loan proceeds, tend to occur at discrete intervals in large amounts. As a result, a firm could have what appears as a favourable or unfavourable cash flow, but one which results from the proceeds of a large borrowing or purchase of a capital asset rather than from recurring operating transactions. Given that financial statement users are primarily interested in the firm’s ability to generate cash from operations, it would be necessary to separate out the effects on cash flows of major transactions such as these. Even within the category of operating cash flows, there can be lumpiness of receipts and payments -- for example, a large collection on account may come in shortly after year end. Under a strict cash basis, this would not appear as a cash flow in the year. Under accrual accounting, of course, the account receivable (an accrual) appears on the balance sheet and the expected revenue from such a transaction would be included in the financial statements regardless of whether the cash was collected yet or not. In effect, the Framework argues that accrual accounting enables a better prediction of future operating cash flows by recording changes in assets and liabilities in the period in which the major economic activity generating those assets and liabilities takes place. Thus accruals record expected cash inflows as assets and revenues, and expected cash outflows as liabilities and expenses, before the cash itself is received. By smoothing out lumpy operating cash flows and recording their expected amounts in the financial statements on a timely basis, accruals enable a better prediction of cash flows. Presumably, the standard setters feel that the increased relevance of accruals outweighs their lower reliability, thereby increasing decision usefulness.

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The reason for the Kim and Cross finding is that net income is determined on an accrual basis. Since accruals anticipate future cash flows, they remove the lumpiness that operating cash flows often exhibit. For example, revenue recognized from a large sale near the end of the period may not be collected in cash by the end of the period, yet all or most of the cash outflows associated with the sale may have been incurred. Then, operating cash flows for the period would not predict future cash flows as well as net income for the period. Note: A superior answer would point out that if the firm is in steady state, cash collections next period from current period sales would be counterbalanced by cash collections at the beginning of the period from previous period’s sales, in which case net income and operating cash flows would be equal. However, these collections may not cancel out completely, even for a firm in steady state, if operating cash flows are lumpy. Also, if the firm is growing or contracting, this cancelling out would not occur.

Off-main diagonal probabilities of an information system are non-zero when conditions are not ideal. Specifically, low earnings quality, that is, low relevance and/or low reliability will increase the off-diagonal probabilities, resulting in less informativeness or, equivalently, greater noise or less transparency in the system. This reflects the fact that when conditions are not ideal, the financial statements do not provide perfect information about the true state of the firm. High off-main diagonal probabilities can result from low quality GAAP (for example, a claimed reason for a country to adopt IASB standards is that they will increase GAAP quality relative to the country’s current GAAP). Even if GAAP is of high quality, off-main diagonal probabilities can be high if managers lower financial statement reliability by exploiting the flexibility of GAAP, or violating GAAP, to manage the financial statements for their own purposes. Lower off-main diagonal probabilities or, equivalently, higher main diagonal probabilities, produce a more informative information system. That is, a given 101 .

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message results in a better ability to discriminate between states of nature as the noise produced by the off-main diagonal probabilities decreases. In the limit, the off-main diagonal probabilities go to zero and the information system becomes perfectly informative (see Question 1). 7.

The decision-usefulness approach to accounting theory is an approach

which deduces the information needs of financial statement users by studying their decision problems. b.

The two questions which arise are: i)

Who are the users (or constituencies) of financial statements?

ii)

What are their decision problems?

According to the Conceptual Framework, the primary constituency of

financial statement users is present and potential equity investors, lenders, and other creditors who make decisions in their capacity as capital providers. This constituency is called the primary user group. According to the Conceptual Framework, the primary user group needs information about the amount, timing and uncertainty of the firm’s future cash flows. d.

The basic characteristics are that financial statement information should

be capable of making a difference in the decisions made by users, subject to reasonable reliability (representational faithfulness). For this, financial statements should provide an informative information system. To maximize informativeness, the financial statements need the most decision useful trade-off between characteristics of relevance and reliability. e.

Investors are assumed to be risk averse. Investment theory tells us that

risk-averse investors trade-off risk and expected return of securities in making their investment decisions. Specifically, a risk-averse investor will only be willing 102 .

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to accept higher risk if the expected return is also higher, and vice versa. To do this, they need information about the riskiness of securities in addition to their expected return. 8.

Mr. Smart derives the following utilities from the payoffs: 2ln(8,000) = 17.97 2ln(1,000) = 13.82 2ln(5,000) = 17.03 2ln(2,000) = 15.20

Based on his prior probabilities, Mr. Smart has the following expected utilities for the two actions: EU (common)

= (0.50 × 17.97) + (0.50 × 13.82) = 15.90

EU (mutual fund) = (0.50 × 17.03) + (0.50 × 15.20) = 16.12 Thus, to maximize expected utility, Mr. Smart should buy the mutual fund. b.

Let: G = good state of the economy B = bad state of the economy S = evidence obtained from financial statements

Then, by Bayes’ theorem, the posterior probability of the good state is:

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P (G / S ) =

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P (G ) P ( S / G ) P (G ) P ( S / G ) + P ( B ) P ( S / B) 0.50 × 0.75 = 0.88 (0.50 × 0.75) + (0.50 × 0.10)

The posterior probability of the bad state is thus, P(B/S) = 1 - 0.88 = 0.12 Now, the expected utilities for the two actions are: EU (common)

= (0.88 × 17.97) + (0.12 × 13.82) = 17.47

EU (mutual fund) = (0.88 × 17.03) + (0.12 × 15.20) = 16.81 Thus, Mr. Smart should change his decision and buy the common shares. 9.

Denote buying the J Ltd. bonds as a1, and the Canada Savings Bonds (CSB) as a2. Then EU (a1 ) = 0.05 0 + 0.95 5,600 = 71.0915 EU (a 2 ) = 5,400 = 73.4847

John should choose a2 and buy the CSB. Note: Payoffs are specified as gross of initial investment since square root utility is not defined for negative payoffs. b.

By Bayes’ theorem, the posterior probability of S1 is:

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P ( S1 / G ) =

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P ( S1 ) P (G / S1 ) P( S1 ) P(G / S1 ) + P( S 2 ) P(G / S 2 )

0.05 × 0.10 0.05 × 0.10 + 0.95 × 0.80

0.0050 = 0.0065 0.0050 + 0.7600

and P(S2/G) = 1 - 0.0065 = 0.9935. Then, EU (a1 ) = 0.0065 0 + 0.9935 5,600 = 74.3467 EU (a 2 ) = 5,400 = 73.4847

Now, John should buy the J Ltd. bonds. The good news in the financial statements has lowered John’s subjective probability that J Ltd. will go bankrupt. As a result, a decision to buy the bonds now yields greater expected utility than buying the CSBs. 10.

You should agree. It is possible to reduce risk by diversification because,

when more than one risky asset is held and returns on these assets are not perfectly correlated, firm-specific risks tend to cancel out. If one share should realize a low return, there is always the chance that another share in the portfolio realizes a high return. This reduces the variance of the return on the portfolio, hence reducing portfolio risk. b.

Risk cannot be reduced to zero by diversification because economy-wide,

or systematic, risk would still remain. Since this risk is common to all securities, it cannot be diversified away. It shows up as the covariance terms in a diversified portfolio. That is, the returns on 2 securities will be correlated when they are both affected by economy-wide factors. 105 .

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The payoff table for Marie’s decision is: Act

State Not Bankrupt

Bankrupt

a1 (buy bonds)

$1,144

a2 (buy CSB)

$1,064

Based on her prior probabilities and square root utility function, the expected utility of each act is:

EU (a1 ) = 0.6 × 1,144 + 0.4 × 0 = 0.6 x 33.82 + 0 = 20.29

EU (a 2 ) = 0.6 × 1,064 + 0.4 × 1,064 = 32.62 Therefore, Marie should take a2 and buy the CSB. Note: Payoffs are evaluated gross in this question since negative payoffs are not defined for square root utility. b.

From Bayes’ theorem, Marie’s posterior probabilities over the states are: P( NB / LO ) =

0.6 × 0.5 0.30 = = 0.94 0.6 × 0.5 + 0.4 × 0.05 0.32

P(B/LO) = 1.00 - 0.94 = 0.06 The expected utility of each act now is: 106 .

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EU (a1 / LO ) = 0.94 1,144 + 0.06 0 = 0.94 x 33.82 + 0 = 31.79

EU (a 2 / LO ) = 0.94 1,064 + 0.06 1,064 = 32.62, as before. Therefore, while the expected utility of a1 has increased substantially, Marie should still take a2. Note: The reason the decision does not change is the probability of the message LO conditional on the NB state (0.50). We might reasonably expect that this probability should be higher. A more informative financial statement would generate a higher probability of a low debt-to-equity if Risky Mining was in the NB state. This suggests that the debt-to-equity ratio that does not predict the NB state very well. This leads to part c. c.

The new standard will increase the relevance of Risky’s financial statements, since the present value of future employee pensions is now shown on the balance sheet, and net income reflects the change in this present value. This raises the main diagonal information system probabilities. However, the expected, discounted calculations will require numerous estimates. This reduces reliability, thereby lowering the main diagonal probabilities. The net impact on the main diagonal probabilities depends on which effect predominates. Given that the probability of LO conditional on state NB is quite low before the standard (0.50), it seems reasonable that the net effect would be to increase this probability. Presumably, the standard setter also feels that the relevance effect is the stronger or it would not have adopted the standard. Thus, the most likely impact is that the main diagonal probabilities will increase. 107 .

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Note: It may be worthwhile to point out that if the main diagonal probabilities increased even slightly under the new standard, this could be enough to change Marie’s decision in b to a1. If enough investors reacted this way, the increased demand for Risky’s bonds would lower the firm’s cost of borrowing.

12.

The payoff table for Lucas’ decision is: Act

State No Default

Default

a1 (buy bonds)

$160

a2 (buy CSB)

$60

Based on his prior probabilities and square root utility function for net payoff, the expected utility of each act is: EU (a1 ) = 0.55 × 160 + 0.45 × 0

= 0.55 x 12.65 + 0 = 6.96 EU (a2 ) = 0.55 × 60 + 0.45 × 60

= 7.75 108 .

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Therefore, Lucas should take a2 and buy the government savings bonds. b.

From Bayes’ theorem, Lucas’ posterior probabilities over the states are: P ( ND / HI ) =

0.55 × 0.6 0.33 = = 0.87 0.55 × 0.6 + 0.45 × 0.10 0.38

P(B/HI) = 1.00 - 0.87 = 0.13 The expected utility of each act now is: EU (a1 / HI ) = 0.87 × 160 + 0.13 × 0

= 0.87 x 12.65 + 0 = 11.01 EU (a2 / HI ) = 0.87 × 60 + 0.13 × 60

= 7.75, as before. Lucas should now take a1. c.

The standard will increase the relevance of Risky’s financial statements,

since fair value (market value) of the assets is now shown on the balance sheet. This raises the main diagonal information system probabilities. However, the fair value calculations will likely require numerous estimates. This reduces reliability, thereby lowering the main diagonal probabilities. The net impact on the main diagonal probabilities depends on which effect predominates. The standard requires that for this option to be adopted the revaluation must be done reliably, it thus seems reasonable that, since X Ltd. plans to adopt fair value accounting as allowed by the standard, the net effect would be to increase the main diagonal probabilities.

109 .

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a. EU (a1 ) = 0.5 1,089 + 0.5 0 = 0.5 × 33 = 16.5 EU (a 2 ) = 0.5 324 + 0.5 196 = 0.5 × 18 + 0.5 × 14 =9+7 = 16

Ajay should take a1 and invest in AB Ltd., the speculative firm. b.

From Bayes’ theorem, Ajay’s posterior probability of high performance for

XY Ltd. is: P( High / GN ) =

P( High) P(GN / High) P( High) P(GN / High) + P( Low) P(GN / Low) 0.5 × 0.6 = 0.5 × 0.6 + 0.5 × 0.5 0.30 = 0.30 + 0.25 0.30 = 0.55 = 0.55

Then, P(Low/GN) = 1 – 0.55 = 0.45

EU (a 2 ) = 0.55 324 + 0.45 196 = 0.55 × 18 + 0.45 × 14 = 9.9 + 6.3 = 16.2 EU(a1) = 16.5, unchanged from a. Ajay should still take a1 and invest in AB. 110 .

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Based on the new information system, Ajay’s posterior probability of high

performance for XY Ltd. is 0.5 × 0.8 0.5 × 0.8 + 0.5 × 0.2 0.4 = 0.4 + 0.1 0.4 = 0.5 = 0.8

P( High / GN ) =

Then, P(Low/GN) = 1 – 0.8 = 0.2 From which EU(a1) = 16.5, unchanged from a.

EU (a 2 ) = 0.8 324 + 0.2 196 = 0.8 × 18 + 0.2 × 14 = 14.4 + 2.8 = 17.2 Ajay should now take a2 and invest in XY Ltd. The new, higher quality, GAAP adds increased weight to XY’s reported GN. 14.

Your prior probabilities include all information you have up to just prior to

analyzing the CG Ltd. financial statements. They could include information based on an analysis of CG’s past financial statements, plus other news to date about the company from media, websites, speeches by company officials, analyst forecasts, etc. They could also include the results of a study of the current market price of CG shares. If share price is low, this would indicate an unfavourable market evaluation CG’s future prospects, and vice versa. These probabilities are subjective, since they must be assessed by the decision maker. 111 .

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The information system probabilities are objective. They are determined

by the informativeness (i.e., quality) of the information system, that is, of current GAAP. Note: A more elaborate answer would point out that given current GAAP, the information system probabilities may vary from firm to firm because of differences in innate firm characteristics. For example, a firm with high research costs would likely have lower main diagonal information system probabilities than a firm that conducts no research. Also, since GAAP allows some flexibility in accounting policy choice, a management’s choice of accounting policies and the quality of its MD&A disclosure could affect the information system probabilities. See Note 8 of this chapter. c.

By Bayes’ theorem, the posterior probability of the high state, based on

GN in earnings, is: P( High / GN ) =

P( High) P(GN / High) P(GN / High) P( High) + P(GN / Low) P( Low) 0.7 × 0.8 0.56 56 = = 0.7 × 0.8 + 0.3 × 0.1 0.56 + 0.03 59

= 0.95 P( Low / GN ) = (1 − 0.95) = 0.05

Then: EU (a2 ) = 0.95 × 100 + 0.05 × 36 = 0.95 × 10 + 0.05 × 6 = 9.5 + .3 = 9.8 EU (a1 ) = 81 = 9

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The decision is to hold.

15.

a. EU (a1 ) = 0.8 × 5,000 + 0.2 × 2,000 = 0.8 × 70.71 + 0.2 × 44.72 = 56.57 + 8.94 = 65.51 EU (a 2 ) = 0.8 × 5,250 + 0.2 × 1,000 = 0.8 × 72.46 + 0.2 × 31.62 = 57.97 + 6.32 = 64.29 Bill prefers act a1, to buy Company Q. Note: Since the low state payoff for Q exceeds that of P by more than the high state payoff for P exceeds that of Q, and the prior probabilities are the same for each firm, an intuitive answer without calculations to invest in Q is acceptable, providing an explanation is given.. b. Denote good disclosure by G, and poor disclosure by B. Then, by Bayes’ theorem: Company Q P( H / G ) =

P( H ) P(G / H ) 0.8 × 0.8 0.64 0.64 = = = = 0.91 P( H ) P(G / H ) + P( L) P(G / L) 0.8 × 0.8 + 0.2 × 0.3 0.64 + 0.06 0.70

Then, P(L/G) = 1 – 0.91 = 0.09

EU (a1 ) = 0.91 × 5000 + 0.09 × 2000 = 0.91 × 70.71 + 0.09 × 44.72 = 64.35 + 4.02 = 68.37

Company W

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0.16 0.16 0.8 × 0.2 = = = 0.53 0.8 × 0.2 + 0.2 × 0.7 0.16 + 0.14 0.30

Then, P(L/P) = 1 – 0.53 = 0.47

EU (a 2 ) = 0.53 × 5250 + 0.47 × 1000 = 0.53 × 72.46 + 0.47 × 31.62 = 38.40 + 14.86 = 53.26 Bill should still take a1. His confidence in Company Q is increased due to its superior MD&A.

You make this suggestion because Bill is risk averse. Thus, unless the

correlation between the 2 investment returns is perfect, he will benefit by diversifying his portfolio. The benefit arises because both companies are subject to idiosyncratic (i.e., firm-specific) risk as well as economy-wide risk. Idiosyncratic risks tend to cancel out, thereby reducing the total risk of Bill’s portfolio relative to the risk of holding only Company Q, where Bill bears all of Q’s idiosyncratic risk. 16.

Sonja’s expected utilities based on her prior probabilities: EU (a1 ) = 0.4 484 + 0.6 25 = 0.4 × 22 + 0.6 × 5 = 8.8 + 3.0 = 11.8

EU (a2 ) = 0.4 64 + 0.6 64 = 64 =8

Sonja should take a1 and buy the Northern Oil and Gas Ltd. shares. b.

By Bayes theorem: 114 .

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P( H ) P(G / H ) P( H ) P(G / H ) + P( L) P(G / L) 0.4 × 0.7 = 0.4 × 0.7 + 0.6 × 0.1 .28 = .28 + .06 .28 = .34 = 0.82

P( H / G ) =

Thus P(L/G) = 1- 0.82 = 0.18 Then, EU (a1 ) = 0.82 484 + 0.18 25 = 0.82 × 22 + 0.18 × 5 = 18.04 + 0.90 = 18.94 EU (a2 ) = 64 =8

Sonja should continue to take a1. The good-looking financial statements have reinforced her original decision.

Yes, a falling share price is possible. This is because financial statements are not completely reliable. In fact, according to the information system, there is a 0.1 probability that Northern could be in the low state but still report good news in its financial statements. Perhaps Sonja did not read the supplementary information in Northern’s annual report, such as RRA and MD&A. This may have given her some forewarning that the company was heading for the low state. Another reason for the fall is due to risk. It is possible that unfortunate economy-wide or firm specific factors, not known at the time of release of the financial statements, could be responsible. In buying shares, Sonja is exposed to economy-wide risk. She is also exposed to all of the idiosyncratic risk of X Ltd., since she holds only the shares of one company. Diversification would have lowered this latter risk. 115 .

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It appears that the analysts also failed to anticipate the possibility that X Ltd. was approaching a low state, and that an unfortunate idiosyncratic was+ about EU (a1 ) = 0.2risk × 400 0.8 × 0to materialize.

17.

Let the two states of nature be: D

You have the disease

You do not have the disease

Let the messages you may receive be: P

Test results positive

Test results negative

The information system is: Message P

1.00

0.00

.05

.95

State

Since one person per thousand in the population has the disease, your prior probabilities are:

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Pr( D) = .001 Pr( ND) = .999 Your posterior probability of D, by Bayes’ theorem, is: Pr( D / P) =

0.001 × 1 0.001 × 1 + 0.999 × 0.05

= .0196 Thus your posterior probability is slightly under 2%. According to The Economist, most people answer this question with 95%. The point should be clear– probability judgements can be substantially improved by formal use of Bayes’ theorem. It should be noted that random selection for the test is crucial here. If you self selected yourself for the test because you displayed some of the symptoms of the disease, your prior probability of the disease would be higher than the base rate for the population as a whole of 1 in 1,000. Hence your posterior probability would be higher than 2%. Nevertheless, Bayes’ theorem would still be useful in processing your test results.

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Additional Problems 3A-1. A problem that complicates the relationship between current reported earnings and future earning power is when to recognize revenue as earned. IAS 18 states that revenue should be recognized when significant risks and rewards of ownership are transferred to the buyer, the seller has lost effective control, and the consideration that will be received can be reliably measured. For many firms, the point of sale is regarded as the point in the operating cycle at which these criteria are met. Under some conditions, however, it is debatable if the point of sale does satisfy these criteria. If it does not, this can reduce the ability of the information system to capture the relationship between current and future performance. Greater relevance from recognizing revenue early in the operating cycle will increase the main diagonal probabilities of the information system. However, if revenue is recognized too early, problems of reliability will decrease them even more. A case in point is Nortel Networks Corporation. In its 2000 annual report, Nortel stated: The competitive environment in which we operate requires that we, and many of our principal competitors, provide significant amounts of medium-term and longterm customer financing….At December 31, 2000, we had entered into certain financing agreements of…up to $4,100 (millions of U.S. dollars), not all of which is expected to be drawn upon….We may be required to hold certain customer financing obligations for longer periods prior to placement with third party lenders, due to recent economic uncertainty… and reduced demand for financings in capital and bank markets….As well, certain competitive local exchange carriers have experienced financial difficulties….we have various programs in place to monitor and mitigate customer credit risk. However, there can be no assurance that such measures will reduce or eliminate our exposure to customer credit risk. Any unexpected developments in our customer financing arrangements could 118 .

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have a material adverse effect on our business, results of operations, and financial condition. Despite these reservations, Nortel included sales under extended-term customer financing in current revenue. Note 1 (c) to its 2000 financial statements stated, in part: Nortel Networks provides extended payment terms on certain software contracts….The fees on these contracts are considered fixed or determinable based on Nortel Networks’ standard business practice of using these types of contracts as well as Nortel Networks’ history of successfully collecting under the original payment terms without making concessions. Required a.

Discuss the extent to which Nortel’s revenue recognition policy on

contracts for which extended-term customer financing is provided meet the revenue recognition criteria. b.

Which revenue recognition policy—Nortel’s policy, or a policy of

recognizing revenue only as payments are received under extended-term customer financing contracts—results in the highest main diagonal probabilities of the information system? In your answer, consider both the relevance and reliability of the information. c.

On April 11, 2001, The Globe and Mail reported that Savis

Communications Corp. is in default on a $235 million (U.S.) extended term loan facility advanced by Nortel. What does this suggest about the relevance and reliability of Nortel’s revenue recognition policy?

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3A-2. The owner of a building approaches a banker for a loan to improve the property, to be secured by the rental proceeds. After reviewing the application, the banker assesses that, if the loan is granted, there is a 70% probability the rental proceeds will be $100 and a 30% probability the rental proceeds will be $30. Required a.

Assume that the banker is risk neutral. How much would the banker be

willing to lend on the security of the rental proceeds? b.

If the banker is risk averse, explain why he/she would only be willing to

lend a lesser amount than in part a. c.

Now assume that if the rent is only $30, the banker assesses a 90%

probability that the building owner will be “bailed out” by the government, in which case the rent would be restored to $100. How much would the risk neutral banker be willing to lend now? If every banker felt this way, what implications do you see for the banking system and the economy. 3A-3 A rational investor has $1,000 to invest. She is contemplating investing the full amount in shares of Company A (a1) or investing it in a risk-free government bond (a2). The investor identifies two states of nature: State H: Company A has high future performance. State L: Company A has low future performance. On the basis of her prior information about Company A, the investor assesses the following subjective prior probabilities: State H: 0.2 State L: 0.8 The following is the payoff table for these two investments. Payoffs are net of 120 .

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(i.e., they exclude) the original investment. State H

$324

$ 36

$36

Act

The investor is risk-averse, with utility equal to the square root of the net payoff. Required a.

On the basis of her prior probabilities, which act should the investor take?

Show calculations. b.

Instead of acting now, the investor decides to obtain more information

about Company A by careful reading of its annual report. The investor, who is an expert in financial accounting and reporting standards, knows that they are based primarily on historical cost accounting and the lower-of-cost-or-market rule. The quality of financial statements prepared according to these standards is expressed in the following information system: Current Annual Report Evidence GOOD

BAD

0.6

0.4

0.1

0.9

State

Good evidence means that a company reports increased profits and adequate working capital. Bad evidence means that the company’s 121 .

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profits are down and working capital is low. Upon reading the current annual report, the investor finds it is Good. Which act should the investor take now? Show calculations. c. Assume that the accounting standards are revised to require fair value accounting for major asset classes. Evaluate, in words, the impact of this revision on the quality of the information system.

122 .

Suggested Solutions to Additional Problems 3A-1. a.

Points to consider •

It does appear that Nortel has made a sale when it extends financing to customers, since a contract exists. Nortel claims that the fees on these contracts are fixed and determinable, supporting the criteria that significant risks and rewards of ownership are transferred to the buyer, the seller has lost effective control, and the consideration that will be received can be reliably measured.

•

Has Nortel performed its obligations? If the contract includes extended-term vendor financing, Nortel has an obligation to provide this financing. Thus the answer appears to be no.

•

Is there reasonable assurance of collectability? Again, the answer appears to be no. Nortel itself provides a warning that its past success in collecting under extended-term financing may not continue, due to current economic uncertainty.

It is important to realize that early revenue recognition increases

relevance. This increases the main diagonal probabilities of the information system. However, the decrease in reliability that accompanies early recognition decreases these probabilities. Nortel’s policy is characterized by high relevance but low reliability. A policy of recognizing revenue as extended-term contract payments are received features high reliability but low relevance. Given the economic uncertainty that Nortel mentioned, it seems that the cash basis provides the highest main diagonal information system probabilities. c.

This default is consistent with the conclusion in b. Recognizing

revenue when the sale to Savis is on the basis of an extended term loan is 123 .

relevant because at the time of the transaction, Nortel must have felt that the loans would be ultimately repaid (otherwise, why enter into the transaction?). Consequently, recognition gives investors information about future cash flows. However, reliability is low due to credit risk, as Nortel points out in its annual report. 3A-2. a.

Since the loan is secured by the rental proceeds, the banker will

receive back either $30 or $100. The expected value of this loan given a risk neutral banker, is: EV = 0.7 x 100 + 0.3 x 30 = 70 + 9 = $79. Thus the risk neutral banker will be willing to lend $79 on the security of the rental proceeds. Note: In decision theory, the $79 is an example of a certainty equivalent. The decision maker is indifferent between a risky gamble of ($100, $30) with probabilities of 0.7 and 0.3, respectively, and $79 with certainty. b.

If the banker is risk averse, he/she will only be willing to loan

less than $79. This is because, for a rational, risk averse decision maker, the expected utility of a risky investment is less than the utility of its expected monetary value (this can be seen from Figure 3.3 of the text). The banker will lower the amount loaned to the point where the utility of the amount loaned is equal to the expected utility of the risky gamble. Note: In other words, the certainty equivalent of a given, risky gamble is lower for a risk averse decision maker than for a risk neutral one. 124 .

To illustrate, suppose that the banker has square root utility. The expected utility of the gamble is: EU ($100,$30) = 0.7 × 100 + 0.3 × 30 = 0.7 × 10 + 0.3 × 5.48 = 8.64

Whereas the utility of the expected value of the loan is U (79) = 79 = 8.89

Thus the risk averse banker’s expected utility of the loan (8.64) is less than the utility of the expected value of the loan (8.89). Thus, the banker will only loan an amount x such that: U ( x) =

x = 8.64

This yields x = $74.65 as the maximum loan. The certainty equivalent of the risky loan is reduced to $74.65 from $79 because of risk aversion here. c.

Because of the probable government bailout, the risky loan is

now characterized by rental proceeds of $100 with probability 0.9 and $30 with probability 0.1. The risk neutral banker’s expected value (i.e., certainty equivalent) of the loan is now: EV = 0.9 x 100 + 0.1 x 30 = 90 + 3 = 93 The banker is now willing to lend up to $93. An implication for the banking system is that bankers are more willing to lend when there is a possibility of government bailout. Indeed, they may not bother to evaluate the intrinsic value of loan applications very 125 .

carefully, since, if the loan gets into trouble, they know that the government will probably rescue them. This phenomenon is a version of the moral hazard problem, since bankers are tempted to “shirk” on the effort needed to properly evaluate and monitor loans. An implication for the economy is that there will be a high level of economic activity, because loans are easy to get. However, there may well be over-investment, with many projects ultimately failing since borrowers have reduced incentive to undertake only high quality projects, and bankers have reduced incentive to monitor loan quality. This situation will continue as long as the government continues its policy of bailing out borrowers and their lenders. However, should it become apparent that the government is unwilling or unable to continue the policy, bankers will stop lending and the economy may collapse. 3A-3 a. EU (a1 ) = 0.2 324 + 0.8 0 = 0.2 × 18 + 0 = 3.6

EU (a 2 ) = 0.2 36 + 0.8 36 = 36 =6

The investor should take a2.

By Bayes theorem:

126 .

P( H ) P(G / H ) P( H ) P(G / H ) + P( L) P(G / L) 0.2 × 0.6 = 0.2 × 0.6 + 0.8 × 0.1 .12 = .12 + .08 .12 = .20 = 0.6

P( H / G ) =

Thus P(L/G) = 1- 0.6 = 0.4 Then, EU (a1 ) = 0.6 324 + 0.4 0 = 0.6 × 18 + 0 = 10.8 EU (a 2 ) = 36 =6

The investor should now take a1. c.

The impact on the information system of requiring fair value accounting is: •

Increased relevance. The information system shows the probabilistic relationship between current financial statement information and future firm performance. By requiring fair value accounting, the relationship between current financial statement information and future firm performance is improved, since current values are the best predictors of future values. This increases the main diagonal probabilities of the information system.

•

If market prices on well-working markets are available for the fair-valued assets, reliability should not decrease, and may even increase. However, 127 .

if market values are not available, the possibility of error and manager bias reduces reliability. The main diagonal probabilities will stay the same, increase, or decrease accordingly. The net effect on the quality of the information system depends on the relative magnitude of these 2 effects. However, it is unlikely that the accounting standard setter would implement the new standard unless it felt the result would be an improvement in financial reporting. Hence the net effect is likely to be an increase in MD&A quality.

Note: Both relevance and reliability effects should be mentioned. However a conclusion that the net effect will increase MD&A quality is not necessary, provided there is some recognition that the 2 effects may work in opposite directions.

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CHAPTER 4 Efficient Securities Markets 4.1

Overview

4.2

Efficient Securities Markets 4.2.1 The Meaning of Efficiency 4.2.2 How Do Market Prices Fully Reflect All Available Information? 4.2.3 Summary

4.3

Implications of Efficient Securities Markets for Financial Reporting 4.3.1 Implications 4.3.2 Summary

4.4

The Informativeness of Price 4.4.1 A Logical Inconsistency 4.4.2 Summary

4.5

A Model of Cost of Capital 4.5.1 A Capital Asset Pricing Model 4.5.2 A Critique of the Capital Asset Pricing Model 4.5.3 Summary

4.6

Information Asymmetry 4.6.1 A Closer Look at Information Asymmetry 129 .

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4.6.2 Fundamental Value 4.6.3 Summary 4.7

The Social Significance of Securities Markets That Work Well

4.8

Conclusions on Efficient Securities Markets

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

Securities Market Efficiency

I do not spend much time on securities market efficiency per se, since most students have been exposed to this concept in previous course work. However, I do consider the following aspects: (i)

The definition of semi-strong form efficiency. I point out that efficiency

here is a relative concept. That is, efficiency is with respect to a set of publicly available information. If this is of poor quality, if there is not “enough” of it in the public domain, or if it is simply wrong, security prices will efficiently reflect this poor information. Then, it is natural to suggest that financial reporting has a role to play in improving the quality and quantity of publicly available information. For example, it can play a role in converting inside information into publicly available information. (ii)

I integrate with Chapter 3 by suggesting that a way to think about

securities market efficiency is to envisage a large number of investors making rational investment decisions, such as Bill Cautious in Chapter 3, interacting in a securities market. Market price is what results from their collective decisions. I also emphasize that belief revision is a continuous process, that is, investors are constantly revising their state probabilities as new information comes in from any source, not just when financial statements are released. This reinforces Beaver’s 1973 argument in Section 4.3 that accounting competes with other information sources for decision usefulness to investors. 130 .

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One of my favourite examples is Beaver’s football forecasting example

(Table 4.1). I use this example to show intuitively how market prices can have efficient properties even though individual investors are fallible. The class will respond with interest to a suggestion that departures from rational decision making are symmetrically distributed (i.e., departures in the sense of not in accordance with the decision-theoretic investment decision described in Chapter 3), so that “errors” in decision making cancel out in the market price. If I make this suggestion, I am careful to point out that it implicitly assumes that the distribution of departures from rational behaviour is unbiased, that is, it is centred on the “correct” security price. This reinforces the point made in Chapter 3 that the decision theory model is interpreted as a model of the average investor, not each individual investor. Discussion of behavioural theories and evidence that suggests that investors on average may be biased is postponed to Section 6.2. It is interesting that the cancelling of errors phenomenon appears in many different contexts. A recent book provides numerous other examples to expand on Beaver’s illustration that, in many different contexts, a group makes decisions that are superior to those of the individuals in the group. Interested instructors may wish to consult The Wisdom of Crowds (2004) by James Surowiecki—see bibliography, also Note 3 to this chapter. 2.

Efficient Securities Markets

I argue that market efficiency is a matter of degree (as opposed to the market being either efficient or not efficient) and conclude (Section 6.7) that securities markets are usually close enough to being fully efficient that the efficient securities market model is the most useful model to guide accountants as to the information needs of financial statement users and the social role of financial reporting. Consequently, an understanding of the theory and implications of securities market efficiency is still important for accountants. Securities market efficiency theory, and, more generally, economic models which assume that individuals are rational, have received severe criticism as a result of the 2007-2008 market meltdowns. This is largely because the rational theory did not predict 131 .

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the meltdowns. In this edition, I work hard to defend rational decision theory from these criticisms. This defence begins in Section 4.5.2 (optional section) with an explanation of the rational expectations, common knowledge, no inside information, and perfect liquidity assumptions on which many rational economic models, including the CAPM, draw. While the main purpose in Section 4.5.2 is to acquaint the interested reader with these assumptions and their significance, they anticipate my argument, more fully developed in Sections 6.5, 6.6, and 6.7, that if rational economic modelling is to recover from the criticisms, theorists should consider dropping these assumptions. That is, arguably, it is not lack of (on average) investor rationality that is the real culprit, but rather the failure of many economic models to recognize (common knowledge assumption) that the securities market contains different classes of investors with different levels of ability and information, and a failure to consider more closely (rational expectations assumption) how investors process information. The market meltdowns have also increased accounting researcher’s attention to market liquidity—Section 7.7 gives a brief discussion. A more detailed defence of investor rationality, including outlines of rational models which drop rational expectations or common knowledge, is given in Section 6.5. 3.

Implications of Securities Market Efficiency for Financial Reporting

I always assign Beaver’s 1973 article (Section 4.3) as supplementary reading, followed by discussion in class. While quite old, the article is still relevant, and it is quite readable. The main point I make is that managers should not care about accounting policy choice if one takes securities market efficiency literally. With an eye to the future direction of the text, this argument conflicts with the message of Chapter 8 on contract theory and economic consequences, which is that managers do care. Chapter 9 works to reconcile these seemingly inconsistent observations. 4.

The Demand for Financial Accounting Information When Securities Markets are Efficient

A literal interpretation of securities market efficiency may suggest a limited scope for useful financial statement information. One argument is that historical cost-based 132 .

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financial statements may be superseded by more timely information sources. Another argument is that whatever information content financial statements have will very quickly get built into share price when markets are efficient. Thus, for most investors, share price already reflects what they might learn from the financial statements. To “wave the flag” for financial reporting, it is important to counter such arguments. To do so, I begin with a very intuitive discussion of Grossman’s (1976) argument given in Section 4.4.1, that share prices will self-destruct if they are fully informative, that is, if they always fully reflect all publicly available information. Students usually have no difficulty in seeing this intuitive argument, particularly if it is related back to the Beaver football forecasting example by asking what would happen if the various forecasters gave up on gathering information and simply agreed on a consensus forecast. I then ask the class why share prices do not collapse as predicted by Grossman’s argument, and steer the discussion to the concept of noise traders. I end up by emphasizing that noise trading introduces a random component into share price. It is important to point out that share prices are still efficient, but in an expected value sense. That is, because noise has expectation zero, share price is on average an unbiased reflection of publicly available information. But, at any point in time, noise traders may cause price to depart from this fully informative value. This reconciles securities market efficiency with a continuing motivation for private information search to discover over- or under-valued securities. Hopefully, at least some of this private information search will be directed to accounting information. The private information search argument can be strengthened by pointing out that there is often not a clear dividing line between inside and outside information, and that astute private information search may ferret out such inside information. 5.

Information Asymmetry

In Section 4.6 I come back to the problem of adverse selection introduced in Chapter 1. I begin with an intuitive discussion of the “lemons” problem as analysed by Akerlof (1970). Students readily see the analogy between the used cars market and the securities market. I then ask what mechanisms there are to prevent securities market 133 .

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collapse because of the adverse selection problem of inside information. The following are worth some discussion: (i)

Penalties, such as investigations, fines and publicity for insider trading

violations. (ii)

Incentives, such as full disclosure of lots of relevant and reliable

information. I point out that such disclosures must be credible and ask whether (audited) financial statement information is more credible than other sources, such as information on company websites, speeches by company officials, and media reports. I bring out the concept of estimation risk, noting that this risk is similar to the risk faced by the purchaser of a used car. Estimation risk is an important concept running throughout the text. It explains why better disclosure can reduce a firm’s cost of capital (the CAPM cannot explain this, since it ignores estimation risk-- its only firm-specific variable is beta). Estimation risk also helps to explain why reporting on firm specific risk (e.g., MD&A) is useful. Note that reduction of estimation risk, disclosure of inside information, and control of adverse selection are similar concepts, and that full disclosure helps attain all of them. Finally, I find Figure 4.2 helpful in developing the concept of fundamental value of a security. In particular, the gap between the (semi strong) efficient market price of a security and its fundamental value represents inside information (information asymmetry), which full disclosure can reduce.

The Social Significance of Securities Markets that Work Well I usually refer briefly to this section, by asking the class what makes financial reporting valuable. This is a good occasion to point out to the students that, as accountants, they are working for the good of society, not simply for the good of the client or employer. The demise of Arthur Andersen & Co. (not covered in this book), who were the auditors of Enron, WorldCom, and several other firms with overly aggressive accounting, illustrates this point. Instructors who introduce ethics into their classes may wish to develop this argument further. 134 .

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

The differing market response could be explained by a difference in the market’s expectations of earnings. The net income of the firm that had the strong reaction may have been higher than expectations, whereas the net income of the other firm may have been equal to or less than expectations. Another reason could be a difference in the quality of earnings. The firms may have used different accounting policies. For example, one firm may have used declining-balance amortization and, generally, superior disclosure, whereas the other may have used straight-line, and minimal disclosure. If the accounting policies of one firm are more informative than those of the other (see also Note 8 of Chapter 3), the main diagonal probabilities of its information system would be higher, inducing a stronger market response. Finally, the informativeness of price could have differed between the two firms, although this is less likely when the firms are the same size. However, the firm whose share price changed only slightly may have released more information during the year, say by quarterly reports, forecasts, or manager speeches, and an efficient market would build this information into the share price prior to the earnings announcement.

Pr ice to earnings ratio =

Market value per share Net income per share

For a rapidly growing firm, we would expect it to report lower net income under declining balance amortization than under straight-line, other things equal. Thus, even though their reported net incomes are the same, a dollar of current net 135 .

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income suggests higher expected future payoffs for firm A than firm B. Since investors value higher future payoffs and the higher share returns these imply, firm A should sell at a higher price-to-earnings ratio than firm B, all other things equal. The above follows from efficient markets theory. The market is not fooled by the same reported net incomes for firm A and firm B. Rather, it perceives the impact of accounting policy choice on current earnings and the implications of such choice for earnings quality and future payoffs. If the market did not look through reported earnings this way, we would expect that firm A shares would trade at the same price as firm B’s because the market would then react naively to the bottom line. Note: This answer assumes that both firms claim the same amount of depreciation for income tax purposes. This seems reasonable since the firms are similar, and most jurisdictions, such as Canada, impose their own tax depreciation regulations. If tax depreciation is on a declining-balance method, Firm A would pay less tax than B, but its income tax expense would include deferred income tax. This should not affect the discrepancy between their price earnings ratios.

This occurs if the market perceives the new car dealer as more reputable

than the used car dealer. Then, estimation risk of buying a used car is relatively low. For example, the new car dealer may stand behind used cars sold to a greater extent than the used car dealer. The new car dealer may offer a superior warranty. Also, it may be perceived that the new car dealer will be in business longer; therefore, better able to honour the warranty. In effect, the market perceives the average quality of used cars sold by the new car dealer as superior, and thus buyers are willing to pay more. b.

This question illustrates the moral hazard problem. Homeowners will exert

less effort to prevent fire if they know the insurance company will reimburse them for the full amount of losses. By sharing in any loss, homeowners are motivated 136 .

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to be more careful. The moral hazard problem arises because of information asymmetry — the insurance company cannot directly observe the effort devoted by homeowners to prevent fires. If direct observation were possible, payment of a claim could be made contingent on satisfactory prevention efforts, and a deductible would not be needed. c.

Life insurance companies have such a requirement because of the

adverse selection problem. Life insurance applicants know more about their health than the insurance company does. Thus, people of poor health will have a greater incentive than healthy people to take out a policy. In the face of this information asymmetry, the insurance company has a doctor examine the applicant. d.

The answer is similar to part a. There is information asymmetry between

the seller and the buyers of the new share issue because the firm will know more about its current position and future prospects than the buyers. An efficient market thus knows that it is facing an adverse selection problem. To reduce estimation risk surrounding the share issue, the firm engages a reputable investment house and a prestigious auditor to credibly convey to the market that the information contained in the prospectus is reliable. The information is credible because the market realizes that the firm would not hire reputable, and presumably expensive, professionals to attest to misleading or poor quality information. 4.

The financial press should provide a relevant source of information for investors. The information provided by the financial press is not subject to the constraints and format of financial statement information. Consequently, it has the potential to be much more wide-ranging, timely, and future-oriented. The press does not have to wait until transactions, such as revenue-generating transactions, are realized with sufficient reliability to be entered into the financial accounting system. Consequently, the press has the potential for considerably greater relevance. However, for the same reasons, the press may be less reliable. For example, since media reporters are reluctant to reveal their sources, it may it 137 .

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may be difficult to verify their information. Thus, we can think of the financial press as being more relevant than financial statement information but less reliable, while financial statement information is more reliable, but less relevant. The two information sources therefore complement each other. 5.

One reason is that 1992 fourth quarter earnings came in lower than

expected by analysts and the market, and, for the whole year, earnings were near the lower end of analysts’ forecasts. Since expected 1992 earnings would already be built into the firm’s share price by an efficient market, actual earnings lower than expectations would cause the share price to fall, as investors revised downwards their beliefs about future firm performance. Also, if fourth quarter 1992 earnings were less than analysts’ forecasts, but annual earnings within the analyst forecast range, this suggests that some previous quarters were above-forecast. The market may have interpreted this as indicating a trend of lower future earnings, which would contribute further to GE’s share price fall. A second reason is that GE’s earnings quality may have changed. Perhaps GE switched to less informative accounting policies during 1992. If the efficient market did not know this until the 1992 earnings were released, it would then ask why the company changed its accounting policies so as to lower earnings quality?” This could trigger a decline in share price at that time due to increased investor concern about information risk. A third reason is the possibility of noise traders. There may have been a large increase in the supply of GE shares coming to the market due to random factors. Finally, there was a downturn in the stock market on the day of the earnings announcement. This would exert downward pressure on all share prices, including GE. The higher GE’s beta, the greater the downward pressure. b.

The new earnings information, together with the market downturn,

apparently lowered investors’ expectations of GE’s future profitability and 138 .

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dividends. In terms of equation (4.2), the market’s expectation of (Pjt + Djt) fell. Since, from equation (4.3), E(Rjt) is determined by Rf, βj and E(RMt), none of which is directly affected by the new earnings information, the current price Pj,t-1 in the denominator of equation (4.2) (here, t-1 is January 21, 1993) must fall to restore the equality of E(Rjt) from this equation with E(Rjt) given by CAPM equation (4.3). Note: To the extent that the market downturn on January 21 lowered E(RMt), GE’s cost of capital E(Rjt) will fall in Equation (4.3). This will further lower E(Pjt) in Equation (4.2), hence GE’s current share price. However, the effect of GE’s lower-than-expected current earnings on its expected future earnings and dividends given above continues to apply. 6.

If securities markets are efficient, lack of comparability of financial statements is not important providing investors have sufficient information to quickly put different firms’ information on a comparable basis and the costs of doing so are low. For this, full disclosure, including disclosure of accounting policies used, is necessary. Then, the market will not be fooled simply because different firms report information on different bases. If so, share prices of firms with noncomparable financial statements should not be affected by a lack of comparability. However, lack of comparability does impose costs on investors to make the necessary adjustments. If these costs are high, say because of poor disclosure, non-comparable information it may not be cost effective, or even possible, for investors to adjust for non-comparability. This will reduce the decision usefulness of financial statements. Then, even an efficient market may be fooled by different accounting policies, affecting share prices. To the extent that investors are not, on average, rational, this effect of non-comparability is increased. Also, if firms choices of financial accounting policies differ (i.e., noncomparability), investors may wonder why some firms choose different policies than others. If the market feels, for example, that some firms’ accounting policies 139 .

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aggressively maximize reported net income, or that a firm has something to hide, investors’ perception of estimation risk will increase, and share prices of such firms will fall accordingly. 7.

Economy-wide factors do not seem to be the reason for the fall in Laurentian’s share price, since the TSX market index rose slightly for the day. The fall was likely due to firm-specific (i.e., idiosyncratic) factors. Since earnings increased from the same quarter of the previous year, even after factoring out a nonrecurring gain, and exceeded analysts’ estimates, this would exert upward influence on share price. Bad news items must have outweighed this good news. Possible reasons for the fall are: •

Continuing investor concerns about loan quality, particularly in view of the CFO’s statement that there was still room for improvement.

•

The dividend did not increase, despite higher earnings. This suggests that management may have concerns about future cash flows and earnings, possibly driven by loan quality issues.

The main point that must be made in your memo is that efficient securities market theory suggests that the market will see through the declining balance amortization policy and will not penalize the firm for any resulting lower reported net income. Thus, there will be no “loss in market value.” It should be noted that for the market to see through the firm's depreciation policy, the policy that is used must be disclosed. Presumably, this is the case since the dissident group of shareholders knows the policy. A good answer will go on to point out that the declining balance amortization has several potential advantages for Concept Ltd. Since capital assets are amortized relatively quickly under declining balance, the assets thereby retained in the business will serve as a hedge against obsolescence, which is appropriate if the environment is volatile. Also, the firm's use of a conservative amortization method can be a credible signal that the firm's future earning power can stand the higher depreciation charges. This may cause investors to place a higher 140 .

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value on the firm so that the market price of Concept's shares could actually rise, rather than fall, as a result of the conservative policy. 9.

The following points should be considered: •

The efficient securities markets would not react. One reason is that the liability does not affect GM's cash flow, since amounts actually paid out to retirees would not be directly affected. Another reason is that the market knew the charge to shareholders’ equity was coming — GM had estimated it at $16 to $24 billion. Given market efficiency, any effects of the charge would already have been reflected in GM's share price.

•

The share price might fall if the write-off exceeded the market's expectations. While cash flows are not directly affected by the writeoff, the amount of the writeoff provides relevant information about what future cash flows for retiree benefits will be. Prior to the writeoff, the market’s expectation may have been at the lower end of GM's previous estimate. Then, the writeoff contains new information — the actual liability of $20.8 billion is higher than the $16 billion expected — which could cause a share price decline.

•

The share price would fall if the market anticipated that the charge would create problems for GM in meeting the terms of debt covenants. This topic has not yet been covered in this book (see Section 8.2) but if the student anticipates it, this should be accepted.

•

It can also be argued that share price might rise. GM's share price might rise if the market felt that the large amount of the charge might cause GM to exercise greater control over its postretirement benefits in the future, thereby reducing its costs and improving cash flow.

•

Another reason for a rise in market price would be that the market may have expected the charge to be at the upper end of GM's 141 .

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previous estimate, namely $24 billion. Then, the lower-than- expected actual charge may lead the efficient market to bid up the share price in response to this “good” news. •

GM would only record the charge if it did not expect future problems with debt covenant would arise. The market may thus interpret the charge as indicating inside information that GM had an optimistic view of its future performance. If so, GM’s share price would rise.

10.

A good answer will distinguish short-run and longer-run arguments. In the short run, the argument to sell the shares is that a loss in your share market value will be avoided, and the cash generated by the sale will provide liquidity and flexibility in its reinvestment. For example, if reinvested in a diversified portfolio, your risk will be substantially reduced. However, it is unethical, let alone illegal, to profit from your inside information at the expense of outside investors, particularly the ones who buy your shares. In the longer run, there are several arguments against sale: •

Your reputation will be damaged if it becomes known that you have profited from inside information. This could lead to loss of job, demotion, or lower compensation

•

You may be subject to lawsuits by outside investors and/ or securities regulators.

•

The firm’s reputation will be adversely affected, particularly if investors expect that the same thing will happen in future. This will reduce the firm’s market value as investors shy away from its shares because of increased estimation risk.

•

The securities market will not work as well as it should to the extent that investors fear your behaviour is widespread. That is, investors will regard 142 .

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all shares as potential lemons. From society’s perspective, this is undesirable since the efficiency of capital allocation is reduced. •

You may lose your job due to violation of company policy, which often requires senior officers to hold substantial amounts of company stock. In addition, many companies impose trading windows on employees, whereby buying or selling company stock is not allowed during a window around the release of financial statement information. Your sale may violate such a policy. It may be difficult for you to secure another comparable job.

•

Partially informative nature of share price. Your sale of shares may alert outside investors, who will wonder why you are selling. While they do not know what information you have, they will reason that the information must be bad news. They may protect themselves by also selling. In other words, your sale may be a vehicle for partial conveyance of inside information to the market. The result would be to lower the value of your company’s shares.

A superior answer will point out that the longer-run arguments against sale above reinforce the ethical argument against sale. 11.

A litigious environment reduces the number of firms that issue forecasts.

Failure to forecast can have a negative impact on the working of securities markets because share prices are then less able to incorporate management’s plans and expectations about future firm performance. As a result, firms with excellent future prospects may be undervalued and firms with poor prospects overvalued, relative to fundamental value. Consequently, the capital market is less able to direct scarce investment capital to its most productive uses. A litigious environment could improve the working of capital markets if it encourages managers to release high quality forecasts rather than forecasts that are biased or otherwise inaccurate. High quality forecasts are easier to defend,

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and less damaging to firm and manager reputation, than low quality forecasts if a lawsuit results from not meeting the forecast. b.

Passage of the bill would increase the number of firms issuing forecasts,

due to lower expected legal liability. However, lower legal liability may lower forecast quality, particularly if managers felt that “cautionary statements” would let them “off the hook” if the forecast was not met. Investors would benefit if the favourable effects on investor confidence in the working of capital markets resulting from more forecasts outweighed the reduction in their quality. c.

Passage would benefit firms if greater investor confidence in the market

as a level playing field resulted from increased number of forecasts. This would reduce the market’s concern about lemons and estimation risk, thereby increasing demand for shares and lowering firms’ costs of capital.

12.

Under securities market efficiency, share prices at all times fully reflect all

publicly available information. Then, there is little point in trying to beat the market price. This requires costly investment analysis with little hope of reward. Instead, a random selection of shares, for example, by “dart-throwing,” will costlessly produce a portfolio with average risk and a rate of return commensurate with this risk. Note: This argument ignores the effect of noise trading. Then, dart throwing is less clearly a desirable strategy since the analyst may be able to identify over or underpriced shares by astute financial analysis. b.

According to the CAPM, a return greater than the market (here the Dow

Jones index) can only be generated if higher (beta) risk is borne. Consequently, if the pros earned 10.9% when the Dow Jones earned 6.8 %, the stocks the pros selected must have had relatively high beta risk on average. Note again that this argument ignores noise trading considerations. Perhaps the pros are particularly good at astute financial analysis of publicly available 144 .

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information. Also, a random selection of stocks would be expected to yield an average beta for the portfolio of 1. Yet the darts also underperformed the market index (which has beta of 1). Of course, while a beta of 1 is expected, the actual average beta of the portfolio will differ, particularly if the sample of stocks is small.. Consequently, risk differences are a possible reason for the low return for the darts. To determine if risk differences were driving the results, determine the betas of the dartboard portfolio stocks and of the stocks chosen by the pros, for each contest. If the average beta of the pros was higher than that of the darts, this would support the risk difference argument. Calculation of beta could be by use of regression analysis based on the market model, or obtained from the internet. c.

A possible alternative reason is that the pros may have had inside

information. Since the market is assumed efficient only with respect to publicly known information, inside information can lead to higher returns. It is also possible that the pros were simply lucky. However, this possibility is very unlikely since the returns were averaged over 100 contests. Also, the pros beat the market return. Note: A related contest was conducted by The Globe and Mail. See, for example, the article by Andrew Bell, 9 January, 1999, p. B6. Here, 8 pros picked a stock, with the returns compared with the TSE 300 index and, in place of darts, with a stock (Pet Valu) picked by a reporter’s cat. For 1998, 4 pros beat both the TSE 300 and the cat and the other 4 pros were beaten by the TSE 300 and the cat. The average return for the year was -11.3% for the pros, -1.6% for the TSE 300 and +4.0% for the cat. I am indebted to Andrew Bell, Investment Reporter for The Globe and Mail, for the above information. 13.

The following points should be considered:

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Revenue is the “lifeblood” of a business. Consequently, revenue growth suggests future profitability, particularly in the presence of fixed costs—once revenue rises to the point where fixed costs are met, profitability can rise very quickly. This suggests that revenue growth has potential as a predictor of future earning power.

•

However, since net income includes both revenues and expenses, net income or loss has at least as much potential as a predictor of future earning power as revenue growth.

•

The efficient market can adjust for research and startup costs, assuming these are disclosed, and will not penalize the firm for low or negative of reported earnings to the extent it feels these costs have future potential. If the firm’s share price is not penalized, immediate writeoff of these items is not an argument that supports concentrating on revenue growth as a predictor of future earning power.

•

The income statement contains information that may assist the efficient market in interpreting revenue growth. For example, in the case of Imax Corp., bad debt expense should incorporate the expected amounts of customer defaults on long-term contracts. Also, Bid.Com will include the (net of commission) price paid by the buyer in cost of sales, since this amount will be paid to the previous owner of the sold item. Thus, its gross profit will not be mis-stated.

•

MD&A contains information that assists in interpreting net income and assessing future firm performance. This adds to the ability of net income to help investors to predict future firm performance.

A reasonable conclusion is that revenue growth has some information content as a predictor of future earning power but that it is not a substitute for net income. Rather, revenue growth, net income or loss, and supplementary information such as MD&A should all be considered. 146 .

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The earlier revenue is recognized in the firm’s operating cycle, the more

relevant is revenue growth information, since this provides an earlier reading on future revenues and earning power. Prediction of future earning power is the essence of relevance. Consequently, policies such as those of Imax and JetForm are high in relevance. It is difficult to defend Bid.Com’s policy from a relevance perspective since this policy does not involve the timing of recognition, but only the amount. c.

The revenue recognition policies of Imax and JetForm are low in reliability,

however. This is because of the likelihood of customer defaults and unexpected costs on contracts in process. While estimates of these costs are included in the determination of net income, the estimates are subject to error and possible bias, thereby reducing reliability. Revenue recognition is thus subject to similar trade-offs between relevance and reliability as is the valuation of assets and liabilities. d.

If revenue recognition policies such as those described exist, but firms do

not disclose whether or not they are engaging in them, the main diagonal probabilities of the information system are reduced. That is, earnings are of lower quality than they would be in the presence of full disclosure. In effect, the firms that engage in these practices are lemons. The efficient market will respond with a pooling effect, reducing its confidence in financial reporting for all firms. There will be reduced share price response to the GN or BN in earnings. As a result, securities markets do not work as well as they might due to a reduced ability of the efficient market to identify firms with high and low future earnings potential. The result will be a reduction in the efficiency of allocation of scarce investment capital in the economy. 14.

The efficient securities market will react to the expected profitability of a

contract once the contract is signed, assuming that information about the contract is publicly available. Consequently, share price will rise, or fall, immediately regardless of whether the firm is an early or late revenue recognizer. The reported net income of early revenue recognizers will also rise or fall since 147 .

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expected profits will then be included in earnings for the same period as the contract is signed. For late recognizers, net income will not be affected by the contract signing, despite the share price reaction. Consequently, share returns of early recognizers will be more highly associated with the reported earnings of early recognizers than late recognizers. b.

Reliable information faithfully represents what it is intended to represent.

For this, the information should be complete, free from material error, and unbiased (see Section 3.7.1) .Thus, reliable accounts receivable information, net of allowance for doubtful accounts, accurately predicts the amount of cash to be collected (over the next two quarters in Zhang’s study). To the extent cash from opening net receivables is collected in a timely manner (in this case, over the next two quarters), this suggests no material error or bias in revenue recognition and in estimating the doubtful accounts allowance, hence greater reliability. c.

The usefulness of financial statements is higher the higher are the main

diagonal probabilities of the information system. By increasing relevance, early revenue recognition increases the main diagonal probabilities. By decreasing reliability, early revenue recognition decreases them. Whether or not early or late revenue recognition increases usefulness depends on which of these two effects is the strongest. Zhang’s study found higher correlation between share return and reported earnings for early revenue recognizers. Assuming reasonable securities market efficiency, this suggests that investors perceived relevance effects as outweighing reliability effects, since, if they did not perceive this, share return would not be more highly correlated with earnings for early recognizers. To the extent investors were concerned about the reliability of revenue recognition, share return would not rise. Thus, early revenue recognition has the potential to be decision useful. Zhang’s results suggest that the relevance of this information outweighs investor concerns about reliability. 148 .

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Implications of estimation risk for the working of securities markets in our economy: •

Investors are less able to separate good firms from poor firms as estimation risk increases. As a result, their fear that firms are lemons increases, leading to a pooling effect whereby shares of all firms trade further below their fundamental values than they would with less estimation risk.

•

Market incompleteness. With estimation risk present, investors cannot buy shares with the exact risk and return characteristics they desire. In extreme cases, the securities market will collapse.

•

Low market depth. Estimation risk causes at least some investors to leave the market, resulting in fewer shares traded. With fewer shares traded, the resulting decrease in market liquidity causes investors, especially large ones, to fear that they may not be able to buy or sell the number of shares they desire without affecting the market price. This reduces their incentive to buy, resulting in higher cost of capital for firms.

As a result of estimation risk, social welfare is reduced. Shares trade at lower prices than if no estimation risk, and as a result firms face higher costs of capital. Higher costs of capital reduce investment in the economy. Estimation risk can be reduced by full disclosure, thereby moving information from inside to outside of the firm. Full disclosure can be motivated by: •

Regulation. Accounting standards are a form of regulation, as is MD&A. Then, firms are required to disclose.

•

Incentives. The efficient market itself can motivate full disclosure by rewarding firms for voluntary full disclosure policies. The rewards come in the form of higher reputation, leading to higher share price and lower cost of capital.

No, estimation risk cannot be fully eliminated since this would be too costly. For example, the cost to the firm of revealing secret processes, plans for expansion, or takeover bids would be extremely high. 149 .

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Additional Problem 4A-1. In 1994, the AICPA established a Special Committee on Financial Reporting. This committee, made up of several leaders in public accounting, industry, and academe, was charged with reviewing the then-current financial reporting model and making recommendations on what information management should make available to investors and creditors. In 1994, the committee made several recommendations in a report entitled “Report of the Special Committee on Financial Reporting” that it argued should help investors and other users to improve their assessment of a firm’s prospects, thereby improving the usefulness of annual reports. Here is one of its recommendations: Many companies are faced with litigations from investors who feel that they did not live up to their forecasted forward-looking information. “Because of this, managements see disclosure of forward-looking information, even though helpful to users, as providing ammunition for future groundless lawsuits.” This means that a lot of managers are reluctant to disclose forward-looking information. In the light of this situation, the Committee recommended that there be “safe harbors” in order to eliminate “unwarranted litigation” when disclosing forward-looking information. The Committee further suggested that standard setters include rules that are “specific enough to enable companies to demonstrate compliance with requirements.” Source: Excerpt reprinted with permission from report of the AICPA Special Committee on Financial Reporting. © 1994 by American Institute of Certified Public Accountants, Inc. Required a.

Would relieving firms from legal liability for failing to meet forecasts in

MD&A tend to reduce the quality of forecasted information? Explain.

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What benefits for the operation of capital markets would result from

increased forecast quality?

Suggested Solution to Additional Problem 4A-1. a.

The following points should be considered: •

Legal liability disciplines financial forecasting, since managers who issue careless or biased forecasts will face a high probability of lawsuit. According to this argument, relief from legal liability would tend to reduce the quality of forecasts, since managers are then less “under the gun” for forecast accuracy. Presumably, this is why the Committee advocates more specific forecasting rules, since greater specificity makes it easier to hold the manager responsible for failing to meet the requirements.

•

Legal liability, especially in the United States, may have the effect of discouraging the issuance of forecasts, rather than making them more accurate. Consequently, a reduction of legal liability would likely make the issuance of forecasts more common. This is the position of the Committee, since it argues that reduced liability exposure is needed to encourage more forecasts.

•

Requirements that may encourage forecast accuracy include a postmortem, so that managers would be accountable for explaining if targets were missed. The market could evaluate the candour and completeness of the explanation. Knowing this, the manager has an incentive to forecast as accurately as possible.

•

Making forecast requirements more specific, as suggested in the excerpt, could be accomplished through MD&A. At present, requirements to discuss future-oriented information in MD&A are somewhat general and vague as, for example, in the requirement to 151 .

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explain and discuss important trends, risks and uncertainties that are expected to affect future performance. Perhaps more specific forecasting requirements could be included, for example to provide full disclosure and discussion of all risks faced by the firm and to outline how the firm controls these (similar to information that Canadian Tire provides voluntarily). This could increase investors’ ability to predict future firm performance, by reducing fuzzy, vague risk forecasts. •

Greater rules and regulations for forecasts, including in MD&A, would reduce the ability of firms, such as Canadian Tire, to distinguish themselves by going well beyond minimal forecasting requirements. (The concept of a signal could be brought in here.)

The benefits would derive from an improved ability of investors to assess

future firm performance, since management is presumably best placed to know future plans and performance targets. This assumes, however, that forecast quality is not seriously eroded by the reduction in legal liability needed to encourage greater issuance of forecasts. If this is the case, the effect would be to increase the main diagonal probabilities of the information system (Table 3.2). As a result, proper operation of capital markets would be enhanced since capital markets would then be better able to direct scarce investment capital to its most productive uses.

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Chapter 5

CHAPTER 5 THE VALUE RELEVANCE OF ACCOUNTING INFORMATION 5.1

Overview

5.2

Outline of the Research Problem 5.2.1 Reasons for Market Response 5.2.2 Finding the Market Response 5.2.3 Separating Market-Wide and Firm-Specific Factors 5.2.4 Comparing Returns and Income

5.3

The Ball and Brown Study 5.3.1 Methodology and Findings 5.3.2 Causation Versus Association 5.3.3 Outcomes of the BB Study

5.4

Earnings Response Coefficients 5.4.1 Reasons for Differential Market Response 5.4.2 Implications of ERC Research 5.4.3 Measuring Investors’ Earnings Expectations 5.4.4 Summary

5.5

A Caveat About the “Best” Accounting Policy

5.6

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Conclusions on the Information Approach

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

To Appreciate the Value Relevance Approach to the Decision Usefulness of Financial Reporting

I begin coverage of this chapter by pointing out that we are now starting to apply decision theory and efficient securities markets theory to better understand the role of financial reporting to investors. The first step is to develop the concept of value relevance, as empirical testing of the predictions of decision theory and market efficiency. I briefly review the Bill Cautious decision theory example 3.1 and emphasize that it is Bill Cautious, not the accountant, who has the primary responsibility, and motivation, to predict future firm performance. The role of the accountant is to supply useful information in this regard, and not necessarily to make direct predictions about current and future firm value. To the extent that it facilitates investor predictions of future firm performance, historical cost-based information can be useful even though it does not directly reveal values. I often play “devil’s advocate” at this point and suggest to the class that since decision usefulness implies it is not the role of the accountant/auditor to predict future firm performance and value, is the accountant/auditor responsible if it turns out that the financial statements did not foresee financial distress. I try to steer the resulting discussion to a conclusion that while accountants/auditors may like this argument, it is not clear that investors, regulators, and the courts will accept it. I also point out that accountants are in competition with other information sources, pursuant to Beaver’s 1973 paper reviewed in Section 4.3. Repeated complaints by investors that financial distress was not predicted can only erode the accountant’s competitive position. If time, with a view to the measurement approach to be introduced in Chapter 6, I ask if accountants could improve their competitive position by assuming greater responsibility for reporting on current values.

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To Introduce Empirical Securities Markets-Based Accounting Research

The body of research in this area is vast. I concentrate in this chapter on providing a framework within which the research can be interpreted, rather than trying to cover very much of it per se. To establish this framework, I begin by pointing out that the empirical research addresses some very fundamental and interesting questions — do investors use the accountant’s product? If they don’t, of what value is financial reporting? I then argue that the framework is provided by the decision theory model, again referring back to Example 3.1 — if investors find financial accounting useful, then we should see trading volume and securities prices responding in predictable ways to accounting information. Having said this, I then point out that actually finding a securities market response is not easy. I discuss at an intuitive level the various research problems outlined in Section 5.2. I end up this discussion by emphasizing that the basic procedure to find a market response is to associate some measure of market return on securities with some measure of the information content of the financial statements. I then review the 1968 Ball and Brown study. Since their methodology takes some getting used to for students who have not seen it before, I stick fairly closely to the coverage in Section 5.3, although the article itself could usefully be assigned as reading by instructors who wish to consider BB’s procedures in greater depth. I concentrate on explaining how BB operationalized the measurements of market return and information content of net income. Figure 5.3 is useful in this regard. The figure also ties nicely back to the efficient securities market theory of Chapter 4, and the discussion in Example 3.2 of the dichotomization of factors affecting share price into market-wide and firm-specific factors. I go on to review the ERC research outlined in Section 5.4, as an example of an important direction in which the Ball and Brown methodology developed. I bring out how the ERC is a measure of earnings quality, and discuss the various measures of earnings quality. Earnings persistence, in particular, is an important component of 155 .

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earnings quality. Persistence ties in nicely with full disclosure, since poor disclosure can be used to hide low-persistence items. Discussion of one of the chapter problems can be helpful to get across how poor disclosure can lower earnings quality by hiding lowpersistence earnings—see problems 16, 18, 20. Persistence appears later as an important component of Ohlson’s clean surplus theory (Section 6.10.2—optional reading). An interesting exercise is to attempt to estimate the persistent portion of the earnings of a large and complex company from the information in its annual report. Indeed, this could be a useful student assignment, although one that is hard to mark. I tried such an assignment once, but the student answers tended to be fairly superficial. In part, the problem is that earnings persistence is hard to determine precisely. Perhaps, as mentioned above, an in-class case discussion of an actual annual report is a better way to apply the persistence concept. You may have noticed that most of the research outlined in this chapter is now quite old. This is not because this research is no longer relevant to a study of accounting theory, but rather that accounting research has moved on to other topics. I have, however, outlined two more recent studies. Jones and Smith (2011) can be used to introduce the concept of special items and some differences between IASB and FASB practice. McVay’s study of classification shifting provides an interesting example of financial statement manipulation of earnings persistence. Instructors have considerable flexibility to augment the coverage of this chapter, depending on their own interests and backgrounds. I have tried to design the chapter to facilitate this. As mentioned, I provide a decision-theoretic framework within which the empirical research can be interpreted. Also, I provide extensive references to articles upon which the chapter material is based. I have, as well, introduced topics that could usefully be developed further. These include the notions of narrow and wide windows, which lead to the distinction between causation and association in Section 5.3.2, and measuring investors’ earnings expectations in Section 5.4.3. Section 5.4.3 also contains a brief discussion of analysts’ forecasts as a measure of these expectations. This textbook does not give much attention to the considerable research into analyst forecasts, other than to explain such forecasts are a way to 156 .

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estimate expected earnings. However, the coverage here provides an occasion for instructors who wish to dig beeper into issues of forecast accuracy and bias to do so. In particular, the Easton and Sommers 2007 study, and the additional reference in Note 23 provide may be of interest. For instructors who wish to cover securities market response to non-earnings information (hard to find), Section 5.6 considers the study of Lev and Thiagarajan (1993) which suggests that the relationship between balance sheet information and share price shows up via the ERC, rather than directly. Their paper is also useful as a way of bringing out the concept of earnings quality. The paper is quite readable and could be assigned as supplementary reading if desired. More recently, Defranco et al (2011) studied the information content of Note information. This study is more indicative of current capital market research, which often considers the presence of more than one type of rational informed investor. In this edition, I have emphasized some of the limitations of the theory in understanding how information affects capital markets—see the discussion of the assumptions underlying the CAPM in Section 4.5.2 and the outlines of some models that drop these assumptions in Section 6.5 (optional sections). 3.

To Appreciate the Limitations of Empirical Securities Markets Research for Accounting Policy Recommendations

Given that empirical research has established an association between accounting information and the market returns on firms’ shares, it may seem reasonable to suggest that the best accounting policy is the one that produces the highest association. That is, if net income calculated using, say, straight-line amortization is more highly associated with changes in the market value of (i.e., the return on) the firm’s shares than is net income calculated using declining balance amortization, then investors find straight-line amortization policy more useful, since it is more consistent with an (efficient) securities market’s evaluation of the firm. Such reasoning may have the potential to identify the most useful accounting policies from the great variety of policies available under GAAP. If so, could standard setters simply require accounting policies that are most highly associated with changes in the market value of the firm’s shares? 157 .

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I sometimes put this question to the class. While getting a good discussion going tends to be like pulling teeth, some students will see the essential circularity. Adopting accounting policies that have the greatest market response does not inform the market. To clinch this point, ask if the best way to measure a firm’s net income is to drop reporting of net income and, instead, simply report the change in the market value of the firm for the period (adjusted for capital transactions). Assuming reasonably efficient security markets, this would be an economically correct measure of income. However, the answer is no, since nothing is added to what the market already knows. The role of accounting information is to expand and improve the stock of information available to the market, not to reflect it. Another reply to the suggestion to use the association between accounting information and share returns as the basis for accounting policy choice is to point out that the private and public values of accounting information are not the same, leading to the distinction between private and public goods given in Section 5.5. The distinction between public and private goods is at the heart of the Gonedes and Dopuch (1974) paper referenced in Section 5.5. They show that since accounting information has characteristics of a public good, reliance on market prices to motivate firms’ information production decisions does not result in the socially “best” amount of private information production. For example, if a firm enjoys a stronger share price response to the GN in net income when it uses straight line amortization than when it uses declining balance, then the firm may prefer straight line amortization (use of straight line amortization is an information production decision). While this is fine from the firm’s perspective, we cannot conclude from this that straight line amortization is better from society’s perspective. The reason, as explained in the text, is that the market does not bear all the costs of producing the information. Consequently, society cannot use the share price response as a signal of what information firms should produce, as it could for a private good. If the share price response does not incorporate all the costs, we cannot use the correlation between straight line net income and share price as an indicator of the socially best amortization policy. Students sometimes ask that if empirical securities markets research cannot lead to accounting policy recommendations, what is the point of studying it? The response that 158 .

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it helps us to better understand how investors use financial accounting information, while valid, does not seem to settle the issue. I usually fall back on the argument made in Section 5.5 that, despite differences between the private and social values of accounting information, the greater the market response to accounting information the more useful it must be to investors (even though not necessarily to society), hence the greater the accountant's competitive advantage. Also, another cost of accounting information is that managers may not like to report it (recall management’s scepticism about RRA). Consequently, the socially best accounting policy must take managements’ concerns into account. This issue is pursued in later chapters.

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

Value relevance studies the reaction of security returns to accounting information. It assumes average investor rationality and securities market efficiency, under which investors base investment decisions on accounting information providing they find it useful. Greater security market response implies greater decision usefulness, but does not necessarily imply that the accounting policy that creates the greatest market response is socially best. Value relevance is consistent with the historical cost basis of accounting, but does not rely on it. It appears, on the basis of both theory and empirical evidence, that financial statements, traditionally containing a large historical costbased component, do provide useful information to investors. However, there is no particular reason why the information must be historical cost-based. RRA information is not historical cost-based, nor is much of the information in notes and MD&A. These disclosure formats contain a large current value and forward-looking component.

One factor that could adversely affect the accuracy of the estimate of abnormal returns is the estimate of beta, particularly if the firm’s beta changes over time. If the slope of the regression line in Figure 5.2 is not correct, or if beta has changed subsequent to the period over which it was estimated, this will affect the abnormal returns estimate. Another problem is the identification of the date the market first became aware of the earnings news. Usually, this is taken as the date the announcement appeared in the financial press or company conference call. However, if this date is not accurate, then the wrong RMt is used to establish the expected stock return. This would throw off the calculation of abnormal return. There may be other information affecting the firm’s share price on the day of its earnings announcement. For example, the firm may have also announced a change in

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its dividend. Unless such firms are excluded from the sample, any abnormal return will be ascribed to the GN or BN in earnings rather than the other information. A more fundamental problem is that investors may not necessarily make investment decisions the way that the theory developed in Section 3.3 suggests. Investment decisions may not be fully or even partially diversified, in which case beta is not the only relevant risk measure. Or, investors may have some other method of making investment decisions, in which case the market model and CAPM may not provide good estimates of expected and abnormal return. (However, since empirical research has shown that abnormal returns as calculated in Figure 5.2 do relate to GN or BN in earnings, it seems that the investment theory underlying this figure reasonably predicts the decision processes of the average rational investor.) The CAPM makes a number of assumptions. For example, it does not take information asymmetry and resulting estimation risk into account. Consequently, investors may not react to earnings information exactly as the CAPM predicts. For example, they may be concerned about inside information and/or low quality reporting including possible manager manipulation of the financial statements (these possibilities are discussed in later chapters). This could dampen their reaction to the reported earnings. Yet another factor is the significance of industry effects, in addition to market-wide and firm-specific components of return. For example, firm j may be in an industry that is expected to benefit greatly from a reduction of trade barriers. If this reduction was announced around the date that firm j announced its current earnings, the abnormal return around the date of earnings release could be attributed to this industry effect rather than to earnings. 3.

This anticipation up to a year ahead is consistent with the correlation argument. If the firm in an economic sense is doing well, the efficient market learns of this from more timely sources, and responds by bidding up its share price. That is, its abnormal share return rises over the course of the year. Come year-end, the firm reports GN in its earnings, since net income also captures (with a lag) good economic performance.

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Thus, GN will be associated with increasing abnormal returns over the year, but does not cause the market reaction. A similar pattern occurs when firms are doing poorly. The market response in month 0 is consistent with the causation argument. Since a well-designed experiment will remove from the sample firms other firm-specific factors affecting share return, such as dividend announcements and stock splits. Then, the only other firm-specific effect on share return during the narrow window of one month is the release of earnings information. Then, it can be argued that the accounting information caused the market reaction. Of course, this reaction is reduced to the extent the market has anticipated the GN or BN in earnings during the year leading up to the earnings announcement. But, Ball and Brown showed that not all the GN or BN was anticipated, thus causing a market reaction for the month 0. Note: Ball and Brown did not have daily security return data available to them in1968.Consequently, their narrow window is a month. The onus is on the researchers to delete all firms in their sample with non-accounting events affecting share returns. Since a lot can happen during a month that affects these returns, it can be difficult to remove them all. If not all are removed, the findings in month 0 could be consistent with a correlation argument. 4.

Examples of components of net income with high persistence include

permanent changes in sales, as a result, say, of changes in competition, new technology, successful patents, or acquisitions. Permanent cost changes resulting from improved technology, reorganizations, or economies of scale, would also have high persistence. Note: These examples assume that the firm uses historical cost accounting. If the firm uses current value accounting and if expected increases in value from sales and reduced costs are included in net income in the current year, their persistence would be 1, assuming that the market accepted the current value estimates as reliable. b.

Realized gains or losses that are not expected to recur will have

persistence of 1. Gains or losses on disposals of capital assets are examples, to 162 .

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the extent they are not expected to recur and are not part of the firm’s normal operating activities. However, they do generate realized income and the abnormal market return will reflect this. For example, if a firm realizes a $100,000 gain on sale of land, the assets of the firm increase by $100,000, and the firm’s market value will increase by this amount (it would have increased earlier if the market had anticipated the value increase). However, market value will not increase by more than this amount if the gain is not expected to persist. Hence, persistence is 1. c.

Zero-persistence items can result from accounting policy choices that

have no cash flow effects. For example, if a firm capitalizes organization costs, staff training costs, or advertising costs, net income is higher than it would be if these items were expensed. But an efficient market would not react to the increased reported earnings thus created since the decision to capitalize or expense has no effect on cash flows (the cash is spent either way). In effect, these items are value-irrelevant. Persistence can also be zero for gains or losses resulting from accounting policy changes. For example, suppose that a firm reports an increase in income this year because it has changed from declining balance to straight line amortization for its property, plant, and equipment. An efficient market would not respond to such a change as long as it felt that there were no effects on cash flows. Note: In both these zero-persistence cases, the market may wonder why the firm adopted or changed its accounting policy. Then, there could be a share price reaction. This will be considered in Chapter 11. According to the research of Jones and Smith (2011), items in other comprehensive items have zero persistence on average. This is due to subsequent price changes reversing the original unrealized gain and/or, if the item in question is subsequently sold, the unrealized gain or loss is transferred to net income, where its persistence would be 1. 5.

It is desirable to identify the moment when the market became aware of such information because of securities market efficiency. An efficient market will react 163 .

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quickly to new information. Consequently, if the researcher looks for a market reaction even a few days too early or late, no reaction may be found, although one may have existed. The exact time can be found sometimes, but not always. For firms’ earnings announcements, the date of publication of earnings in the financial press, or the date of a press conference or conference call announcing current earnings, seem to be acceptable event dates. However, the exact date on which the market first became aware of information in the financial statements proper can be difficult or impossible to find. When does the market first learn of balance sheet and supplementary information, for example, given the information provided in quarterly reports, forecasts, news reports, and speeches by company officials? There are many such “leaks,” whereby the market may learn of the information early. Then, the exact time may be impossible to find. When an exact date cannot be identified, the narrow window over which the share price response is evaluated can be widened somewhat. For example, a 3 or 5-day window centred around day 0 may be used to capture the possibility that the market may have learned the earnings information a day or two early or late. Alternatively, the researcher may evaluate market response over a wide window of weeks or months leading up to, and possibly following, the formal information release. Then, it may be claimed that there is at least a correlation between abnormal market return and unexpected accounting information. 6.

Yes, a negative ERC is possible. This means that the firm reports positive unexpected earnings but the abnormal share return to these earnings is negative, or vice versa. A firm that reports a net loss for the period, but the loss is driven by expensing of research costs, would have a negative ERC if the market felt that the research costs had sufficient potential for future cash flows to outweigh the BN in reported earnings.

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A negative ERC can also occur if a firm reports good earnings news but other information accompanying the earnings report is negative. An example is provided by the Cisco Systems Inc. vignette 5.1 in Section 5.4.3. Here, Cisco reported GN in earnings but its share price fell because of other, less favourable, information that accompanied the reported earnings. The earnings news was no longer interpreted as good in the light of this additional information.

If a securities market reaction to accounting information is observed during a narrow window of three days around the release of accounting information, it can be argued that the accounting information is the cause of the market reaction. The reason is that, if the research study is properly designed, there are no other firm-specific factors to affect share returns during a narrow window. However, evaluation of returns over a wide window beginning 12 months prior to the release of accounting information opens returns up to a host of other factors. For example, a firm may have discovered new oil and gas reserves, be engaged in promising R&D projects, and have rising sales and market share. In an efficient market, security prices reflect all available information, not just accounting information. Then, the most that can be argued is that accounting information and abnormal market returns are associated. That is, both are correlated with the real economic performance of the firm. The degree of association depends on the degree of recognition lag in the financial statements. A narrow window association provides stronger support for decision usefulness, since it suggests that it is the accounting information that actually drives investor belief revision, and hence abnormal security returns. A wide window association does support decision usefulness of financial accounting information, but to a lesser extent. The wide window association means that net income reflects at least some of the firm’s real economic performance. However, it does not completely reflect real performance. This is because of the recognition lag that characterizes the mixed measurement model. 165 .

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That is, many items of gain or loss are not recorded until after the event leading to a change in share market value has happened. Instead, the accountant waits until reasonable reliability is attained before recognizing many revenue and expense items, particularly with respect to unrealized gains. Note: Recognition lag is the source of the point made in Section 5.3.2 that “prices lead earnings” on an efficient securities market.

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Yes, a stock price decrease is expected, other things equal, because

unexpected earnings were negative $2 million. This conveys bad news to the market. Security prices should react negatively to this information. b.

The share price decrease should be greater for scenario (i) because that

situation reflects a persistent decline in earnings arising from shutdown of a number of retail outlets. In scenario (ii), the earnings decrease is transitory. Hence, XYZ’s common stock price change should be greater in scenario (i). c.

If economy-wide events were such that the whole market rose strongly on

March 31, 2016, this would reduce the decline in the XYZ share value attributed to the firm-specific bad news. If the rise in the market index was large enough to overwhelm the bad firm-specific information, XYZ’s share price would rise. The rise would be less than the rise in the whole market, however. These possibilities can be detected by applying the technique to separate market-wide and firmspecific returns illustrated in Figure 5.2. 9.

Trading volume may have increased in week 0 because investors revised

their probabilities of future firm performance and share returns upon receipt of the current earnings information. These revised probabilities led to portfolio rebalancing and resulting buy/sell decisions. Beaver’s finding that the trading volume increase took place almost completely in week 0 is consistent with securities market efficiency. b.

Trading volume may have dropped below normal during these weeks

because investors were expecting the current earnings announcement and held off on buy/sell decisions until the earnings information was released. c.

Yes, they do. If investors did not revise their beliefs upon receipt of the

earnings information, volume would not be unusual in week 0. The existence of unusual volume, particularly when small and large investors are both in the market, is consistent with the decision usefulness of the earnings information.

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No, low trading volume does not mean that share price change must be

low. The answer depends on the informativeness of the information system, that is, on how decision useful reported earnings are. First, assume reported earnings are highly decision useful (i.e., high main information system diagonals). For small investors, their posterior beliefs about future firm performance will be even more similar than their prior beliefs. Large institutions even though they are confident in their prior beliefs, will put high weight on reported earnings, so that their posterior beliefs will be relatively similar to those of small investors. Similarity of beliefs implies that trading volume will be low. However, share price change will be high since there are few sellers and many buyers (if reported earnings are good news) or many sellers and few buyers (if bad news). Note that this suggests that if reported earnings are highly decision useful, trading volume depends less on the proportion of institutional investors in the market, since all investors will have similar posterior beliefs. However, if reported earnings are low in decision usefulness, posterior beliefs between small and institutional investors will tend to be different, for reasons given in the body of the question. This implies high trading volume. However, share price change will be low since different posterior beliefs imply more equal numbers of buyers and sellers. It seems, then, that the U-shaped findings of Ali, Klasa, and Li (2008) apply primarily to markets where reported earnings are not particularly decision useful. Note: Apart from this question, the text does not discuss models of trading volume. Nevertheless, research has generated analytical models which improve our understanding of both share price and volume reaction around earnings announcement dates. See: •

Kim, O. and R.E. Verrecchia, “Trading Volume and Price Reactions to Public Announcements,” Journal of Accounting Research (1991), pp. 302332. 168 .

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•

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Kim, O. and R.E. Verrecchia, “Market Liquidity and Volume Around Earnings Announcements,” Journal of Accounting and Economics (January, 1994), pp. 41-67.

•

Demski, J. and G.A. Feltham, “Market Response to Financial Reports,” Journal of Accounting and Economics (January, 1994), pp. 3-40.

•

Kim, O. and R.E. Verrecchia, “Pre-announcement and Event Period Private Information,” Journal of Accounting and Economics (1997), pp. 395-419.

The noisiness of volume reaction relative to share price reaction was first shown by Kim and Verrecchia (1991). It appears again in their 1997 paper. The argument that trading volume is low when investors are similar is given in Kim and Verrecchia (1991). 10.

X Ltd. would be expected to have a higher ERC. First, it uses conservative

accounting policies. Consequently, a given dollar of GN has higher implications for future profitability and returns than for Y Ltd. Second, Y’s reported net income may have lower reliability than X because it uses current value accounting for its capital assets. Readily available and wellworking market values may not exist for capital assets, requiring extensive estimates, introducing the possibility of error and bias. The market would be less responsive to unreliable information, other things equal. Note: IAS 16 allows firms to use fair value accounting for property, plant, and equipment, providing that this can be done reliably. Third, X Ltd. is a growth firm. Theory and evidence exists that firms with growth opportunities have higher ERCs than non-growth firms. b.

The answer could change, because firms with higher leverage in their

capital structure, and with high betas, tend to have lower ERCs. If these two effects are strong enough to outweigh the effects in part a, the ERC would be lower for X Ltd. 169 .

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11.

Chapter 5

Theory suggests that rational investors are primarily interested in predicting future firm performance, and will respond quickly to new, publicly available information that is useful in updating their predictions. The empirical evidence in text, Chapter 5 supports the theory, since it appears that security prices, hence abnormal returns, respond to the GN and BN in current reported earnings much as the theory predicts. Also, the evidence of Lev and Thiagarajan (1993) argues that balance sheet information affects the ERC. The ERC research, in particular, suggests that the market is quite sophisticated in the extent of response to net income information.

Beaver, Clarke, and Wright (1979) report, more good news in net income is associated with a greater market response. Since the role of accruals under the Framework is to anticipate future cash flows (Section 3.7.1), thereby overcoming the lumpiness of cash flows, good news in net income thus predicts higher future cash flows, and vice versa. Thus a higher market response the higher is the good news in net income suggests that investors find current net income useful in predicting amounts of future cash flows.

With respect to the timing of future cash flows, Chapter 5 does not present direct evidence that financial statements help investors to assess cash flow timing. However, full disclosure of unusual and infrequent items, so that investors can determine earnings persistence, helps to assess timing. Research by Kormendi and Lipe (1987) and Li (2011), supports decision usefulness of full disclosure, since they demonstrate a market response to the persistence of earnings. The study of Jones and Smith (2011) further emphasizes the argument for full disclosure, since they empirically demonstrate significant differences in persistence of core operating items, special items, and MD&A.

Also, of course, by its nature, the balance sheet helps investors assess timing. Thus cash flows from accounts receivables and inventory will be received sooner 171 .

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than flows from property, plant and equipment. Also, separate reporting of current and long-term liabilities helps investors to assess future cash disbursements.

.With respect to uncertainty of future cash flows, it appears that MD&A, which contains a substantial future orientation, including discussion of risks, is value relevant. This is the conclusion of Li (2010) and Brown and Tucker (2012), who report evidence that MD&A helps to predict future earnings and stock prices, respectively.

Note: Since MD&A is not part of the financial statements, the evidence of value relevance of MD&A, strictly speaking, does not support the Conceptual Framework’s claim. However, as noted in Section 3.6.4, the Framework does state that financial reporting does include management’s explanations.

These empirical results provide strong evidence that the market finds current performance, including MD&A, to be decision useful in assessing the amounts, timing and uncertainty of future cash flows. The Conceptual Framework, which states that information about an entity’s past financial performance is usually helpful in predicting the entity’s future returns, is only partly supported. If investors are rational and securities markets are reasonably efficient, previous years’ performance (i.e., prior to the current year) would already be incorporated into expectations and prices. That is, the usefulness of this information would have largely expired shortly after it was originally reported.

12.

To properly interpret the implications of current reported net income for future firm performance, investors must be able to evaluate earnings persistence. Consequently, low persistence items, such as lawsuit settlements, material writedowns and any reversals thereof, restructuring provisions and any reversals,

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gains and losses on disposals need to be disclosed. Otherwise, investors may over estimate net income persistence. Classification shifting is the inclusion of fixed costs in extraordinary items (FASB) or in low-persistence income statement cost items (IASB}, such as restructuring provisions, lawsuits, etc. It seems reasonable that costs such as these should bear some share of the firm’s fixed costs, such as the costs of full-time employees who plan and implement organizational changes, and costs of the firm’s legal department. However, such costs must be allocated, and the amount of allocation is a subjective judgement. Thus, it is tempting for a management that wishes to increase the apparent persistence of reported earnings to allocate an excessive amount of fixed costs to low persistence cost items. As a result of fixed cost allocation to low persistence items, investors may overestimate earnings persistence, particularly if amounts allocated are excessive. This problem could be reduced by separate reporting of the direct and allocated costs of low persistent cost items. 13.

A public good is a good such that consumption by one person does not destroy it for use by another. Financial statement information has characteristics of a public good, since it can be used by one person and still be useful for others. Consequently, it is difficult or impossible for firms to charge investors for its value, and investors, who do not directly pay for it, may perceive it as free. As a result, there is no properly operating market price to equate supply and demand of information, and some central authority may have to step in to require firms to issue information. Accountants can still be guided by the extent of security market reaction to accounting information. That is, if one accounting policy produces a higher market reaction (e.g., ERC) than another, this policy is found more useful by investors. Since accountants are in competition with other information sources

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about firms' performance and prospects, they are motivated to supply useful information so as to maximize their competitive position. However, it does not follow that standard setters should be guided by security market response in setting accounting standards. For example, if investors perceive accounting information as free, they may demand that standard setters supply more standards than are socially desirable given the costs of producing the information required by those standards. These costs include not only direct costs of preparing, monitoring, and enforcing the mandatory information, but possible costs of loss of competitive advantage if the mandatory information concerns business processes, risk control mechanisms, plans, and prospects. As investors use this information, there may be a security market response, but this response is to a supply of information that is not socially optimal. If the supply of information is not socially optimal, security market response to this information is not socially optimal. Hence, the extent of security response to accounting information cannot be used to guide standard setters in setting socially optimal standards. 14.

Firm K's net income appears to be more useful to investors, because it has a higher ERC. This suggests that increased disclosure, such as financial forecasts to supplement reported net income, will increase the ERC of a firm because investors are better able to infer the future prospects of the firm from reported net income. In particular, if the forecast shows that good earnings news is likely to continue, investors will regard GN in current income as highly persistent and will react more strongly to it. In effect, the main diagonal probabilities of firm K’s information system are higher than those of firm J. Furthermore, the act of issuing a forecast suggests a confident management that knows where it is going, irrespective of the information in the forecast itself. Then, investors perceive less estimation risk and are less likely to pool it into a lemons category. Then, the forecast has signalling properties. Signals are considered in greater depth in Chapter 12.

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This assumes, however, that forecast relevance outweighs the reliability problems of the forecast. This is likely to be the case here, since the question states that firm K’s forecast is of high quality. Firms should not necessarily be required to prepare high quality financial forecasts: •

For some firms, high quality forecasts may not be feasible. This could be the case if the firm operates in a volatile environment, making it likely that there will be substantial errors in estimates and possible biases. If forecast reliability is sufficiently low that it outweighs increased relevance, the net result of mandated forecasts would be a decrease in decision usefulness.

•

The costs to firms of preparing and issuing forecasts may exceed the benefits to investors, particularly if firms are subject to legal liability for forecast errors. Then, mandated forecasts may not be socially desirable, even if investors find them useful.

•

The ability of firms to signal good prospects by the act of voluntarily issuing a high quality forecast is eliminated if forecasting is mandatory.

15.

Note: It is desirable to discuss this problem beforehand. Otherwise, students tend not to see the point of the question. The purpose of this problem is to bring out that, over the life of a firm, all bases of accounting produce the same total net income. This helps us to interpret the concepts of ERC and recognition lag. For example, we know that the ERC of economic income is 1, since under ideal conditions economic income is the increase in the expected present value of future cash flows (allowing for capital transactions), and a dollar increase in the present value of future cash flows will increase firm market value by $1 (assuming investors are diversified). Thus, as the window over which it is evaluated widens, the ERC approaches 1, consistent with the empirical results referred to in the question where total reported net income more closely approximates economic income for longer time periods.

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Conversely, as the time period is shortened (e.g., quarterly reports) the potential for discrepancy between accounting and economic net income increases, so that ERCs can be very different from 1. In effect, the magnitude of the ERC depends on the length of the time period over which it is calculated, as well as the various factors discussed in Section 5.4.1. To put this argument another way, the extent to which historical cost-based earnings lag economic earnings declines as the period over which earnings is aggregated increases, and vice versa. Part c of the question addresses the effect of accruals reversal. For example, if historical cost amortization in one year is greater, say, than economic amortization, the excess will reverse in future periods since the total amount to be amortized is the same regardless of the method of amortization. a.

Cost of capital asset to P.V. Ltd.

$260.33

Less Salvage Value

Amount to be amortized

$260.33

Straight Line amortization per year

$130.17

Then, P.V. Ltd.’s net income under historical cost accounting with straight-line amortization is:

YEAR 1

YEAR 2

TOTAL

$150.00

$165.00

$315.00

Amortization Expense

130.17

130.16

260.33

Net Income

$19.83

$34.84

$54.67

Sales (incl. interest on opening cash)

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Under present value accounting as per Example 2.1 we have economic income as accretion of discount: Year 1

260.33 × .10 = $26.03

Year 2

286.36 × .10 = 28.64

Total net income

$54.67

b. Under historical-cost-based straight-line amortization, P.V. Ltd.’s net income is:

YEAR 1

YEAR 2

TOTAL

Sales (incl. interest)

$100.00

$210.00

$310.00

Amortization Expense

130.16

130.17

260.33

Net Income

$(30.16)

$79.83

$49.67

Under present value accounting as per Example 2.2 we have: Net loss, year 1 (bad state realized)

($23.97)

Net income, year 2 (good state realized) Accretion of discount

236.36 × .10 = $23.64

Abnormal earnings Actual cash flow

$200.00

Expected cash flow 150.00

50.00

$73.64 $49.67

Note: The $10 of interest is subsumed in accretion of discount. There are no abnormal earnings for interest, since expected and actual interest are equal. 177 .

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Amortization is an accrual. The greater the amount of the accrual in year 1 the less remaining to be amortized in year 2, since the total amount to be amortized over the asset’s life is constant at $260.33. Thus, the lower net income under straight line in year 1 (e.g., $19.83, compared to $26.83 for present value income, in Part a) reverses in year 2. The result is that total net income over the 2 years equals total economic income of $54.67. A similar conclusion holds for Part b. Note: A similar conclusion holds for any other basis of amortization as well as straight line. Yes, the results are consistent with EHO and WW, who found a higher association between earnings and share returns as the time period is lengthened. Note: As an example of how this finding can affect the ERC, note that in our example year 1 net income is lower under straight line amortization than under economic amortization, that is, it contains BN relative to economic income. An efficient market would not react to this BN, however, since it knows that the higher-than-economic amortization in year 1 will reverse in the next. That is, the ERC under straight line amortization is less than 1 in the shorter period. d.

Investors usually cannot wait until the firm is wound up in order to know

the firm’s income. Most investors have a shorter decision horizon than this. Thus, they need information on a timely basis. Then, accounting policies and full disclosure matter to them since they prefer those policies and disclosures that best predict future firm performance.

16.

Expected utility of each act, based on Leo’s prior probabilities: EU (a1 ) = 0.3 2500 + 0.7 25 = 0.3 × 50 + 0.7 × 5 = 15 + 3.5 = 18.5 178 .

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EU (a 2 ) = 0.3 225 + 0.7 225 = 225 = 15

Leo should take a1. b.

By Bayes theorem: P( H ) P( B / H ) P ( H ) P ( B / H ) + P ( L) P ( B / L) 0.3 × 0.4 = 0.3 × 0.4 + 0.7 × 0.8 .12 = .12 + .56 .12 = .68 = 0.18

P( H / B) =

Thus P(L/G) = 1- 0.18 = 0.82 Then, EU (a1 ) = 0.16 2500 + 0.82 25 = 0.16 × 50 + 0.82 × 5 = 8 + 4.10 = 12.10 EU (a 2 ) = 225 = 15

Leo should now take a2. c.

You do not agree. The X Ltd. stock is low-beta. Consequently, it is unlikely

that economy-wide events would produce a significant share price increase for X Ltd. d.

Possible reasons for positive market response: 179 .

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•

X Ltd’s earnings may have contained low-persistence losses and other accruals. As a result, operating earnings and cash flows may be good, even though the statements themselves look bad. High operating earnings and cash flows suggest higher profits in future, hence an increase in share price as an efficient market anticipates these profits.

•

According to X Ltd,’s information system, the probability of reporting bad financial results when the company is actually in the high state is quite high (0.4). This suggests considerable conservatism in GAAP and, in particular, in X Ltd.’s accounting policies. An efficient market would recognize this, and regard the company as in the high state despite its Bad reported financial results.

•

Low leverage in capital structure. Low leverage means that equity investors need not be concerned that low net income will result in higher interest expense as debtholders demand higher interest rates, or even taking over the firm. This reduces any negative equity investor response to low reported net income.

•

MD&A contains supplemental information about firm prospects and risks of X Ltd. X Ltd. management may have reported positive future prospects and good risk controls in MD&A, to which the market will respond positively. The advisor consulted by Leo may not have considered X Ltd’s MD&A since MD&A is not part of the financial statements.

•

High research costs. Since research costs are expensed, net income will be lowered. However, ane efficient market will respond positively to the expected future payoffs from current research.

•

Firm-specific (i.e., idiosyncratic) events happening after the release of the annual report. Favourable new developments, such as changes in management, or reduction in competition, new discoveries, increases in fair values, potential buyout offers, would cause a rapid increase in share price, particularly given market efficiency.

The initial rise in Canadian Tire’s share price occurred for 2 reasons:

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Reported earnings exceeded analysts’ expectations. Since analysts’ earnings forecasts are a proxy for investor expectations, investors will raise their probabilities of high future firm performance when earnings exceed forecast. The resulting buy decisions raised share price.

•

The rise in share price was reinforced by Mr. Sales’ comment that the firm is pleased with its ability to deliver double-digit earnings growth. This suggests reasonable persistence in Canadian Tire’s increase in earnings.

The subsequent fall in share price was due to the market’s rapid realization that the persistence of Canadian Tire’s earnings increase was less than at first believed. This was due to the inclusion of an $8 million one-time gain in operating earnings. Note: it is not clear how the market learned quickly about the one-time gain. One possibility is that investors and analysts asked for more information about the increase in operating earnings than was contained in the news release. Another is that the financial statements were released shortly after the news release, and these disclosed separately the one-time item. b.

Yes. IAS 1 requires that realized gains and losses such as from sale of

assets be included in net income. Where Canadian Tire went wrong was not to disclose the details of this low persistence item in the news release. Note: Canadian Tire reported under Canadian accounting standards at the time, not under IASB standards as at present. However, any accounting standards, including Canadian, would require a realized gain such as this to be included in net income, although different sets of standards differ in its location. c.

Persistence seems low. Inclusion of the one-time gain lowers persistence of

operating earnings. Also, if the one-time gain is excluded, Canadian Tire’s earnings per share were lower than for the same quarter of the previous year. If this trend continues, even the gain-excluded earnings will not persist. 181 .

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The fact that Mr. Sales ignored this item in his news release reinforces concerns about low earnings persistence.

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Closing Imperial Oil share price, October 18, 2001 Decline in share price for the day Opening share price, October 18, 2001

$37.35 1.25 $38.60

The actual return on Imperial stock on October 18 was thus: Rjt = -1.25/38.60 = -.03238 The expected return on Imperial stock, from the market model, and using the theoretical relationship αj = Rf (1 – βj), was E(Rjt ) = Rf (1 – βj ) + βRMt = .0002(.35) + .65(.0060) = .00007 + .00390 = .00397 Abnormal return was thus: -.03238 - .00397 = -.03635. or about -3.6% b.

Yes, the decline seems consistent with efficient securities market theory. Net

income, while it was at a record level, was in line with analysts’ expectations. Thus, we would not expect Imperial’s share price to rise on October 18 due to GN in earnings. Furthermore, persistence of the increase in earnings seems low. Earnings include a $60 million one-time gain. In addition, there are concerns about the future price of heavy crude, and oil sands production problems. The efficient market would respond to low earnings persistence by bidding down share price.

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Persistence of net income before the foreign exchange gain seems reasonably

high, since the dramatic increase in these earnings, from a loss of $32 million in Q3, 2003 to a gain of $82 million in Q3, 2004, is likely due to the “red-hot” materials and energy sector. Assuming that prices in this sector were unlikely to fall in the foreseeable future, current core earnings will continue. Persistence of the foreign exchange gain is less clear. If the Canadian dollar should continues to appreciate relative to the U.S. dollar, the gain will persist, and vice versa. Overall, the persistence of net income seems mixed. Since the foreign exchange gain of $239 million dominates the increase in net income, and since foreign exchange rates are volatile and difficult to predict, a reasonable conclusion is that persistence of net income is relatively low. Note: A further persistence argument is that raw materials and energy prices are also volatile and difficult to predict. Should they rise, and assuming that Abitibi has some monopoly power, it should be able to pass increasing materials and energy costs on to customers. Should raw material and energy prices fall, Abitibi may be able to maintain product prices, again to the extent it has monopoly power. A reasonable conclusion s that the volatility of raw material and energy prices would not lower, and may actually raise, net income before foreign exchange gain. This would increase earnings persistence. b.

Probably, low R&D costs would have little effect on the company’s ERC since

low R&D means that there is little anticipation by an efficient market of future earnings from current R&D expense. c.

Note: Superior answers will back up their explanation with calculations as

follows: Closing S&P TSX index on Oct. 21/04 Gain during day

8847 59

Opening S&P TSX index

8788 184 .

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Market return = 59/8788 = .00671 The opening price of Abitibi shares on Oct. 21 was: 7.29 – .59 = 6.70 The actual return on Abitibi stock on October 21 was thus: Rjt = (7.29 – 6.70)/6.70 = .08806 The expected return on Abitibi stock, from the market model, and using the theoretical relationship αj = Rf (1 – βj), was E(Rjt ) = Rf (1 – βj ) + βRMt = .00020(.221) + .779(.00671) = .00004 + .00523 = .00527 Abnormal return was thus: .08806 - .00527 = .08279 or about 8.28% Consequently, the CEO’s claim that the market underreacted is questionable. Relevant considerations include: •

The analyst’s forecast for Q3/04 was a loss of $27 million, but earnings, both before and after the foreign exchange gain, were strongly positive. The 8.27% abnormal increase in Abitibi’s share price is consistent with the market regarding Q3 earnings as GN. Perhaps the market felt that foreign exchange gains were of low persistence, or, at least, would average out to zero, thereby putting relatively more weight on the pre-foreign exchange gain earnings increase.

•

The CEO may have had inside information about future increases in product prices and foreign exchange rates, future plans for U.S. financing, and 185 .

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hedging strategies. His claim that the market underreacted may be a way of signalling this information without revealing it specifically. If so, this would increase earnings persistence and share price response. However, the market may not have interpreted his comment this way. Overall, it seems that Abitibi’s share price increase was consistent with securities market efficiency. 20.

The return on the market portfolio (i.e., the NYSE Composite Index), ignoring

dividends, on September 13 was (7578.25 – 7762.60)/7762.60 = -184.35/7762.60 = -.0237 According to the market model, the expected return on Best Buy’s stock on that day was: E ( R jt ) = (1 − β j ) R f + β j RMt = −.84 × .0001 + 1.84 × −.0237 = −.0001 − .0436 = −.0437 or -4.37%, where use is made of the relationship αj = (1 – βj)Rf.

The abnormal return on Best Buy’s stock on September 13, 2005 was - .1020 + .0437 = - .0583

This decline of almost 6% is worse than the expected decline of 4.37%. The market must have interpreted the information in the company’s earnings announcement as bad news. Explanations for the bad news interpretation: •

The market was expecting earnings of 38 cents per share for the second quarter based on analysts’ forecasts. Actual earnings came in at 37 cents. Under market efficiency, Best Buy’s stock price on September 12 would have incorporated this expectation. Thus, the market was disappointed. 186 .

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Stock price also included an expectation of 34 cents earnings per share for the third quarter, whereas the company’s current forecast was for earnings in the range of 28 to 32 cents.

•

Investors were worried about the effects of hurricane Katrina on the company’s near-term profitability.

•

Investors were worried about the effects of high energy prices on consumer spending.

All of these reasons would cause rational investors to revise downwards their expectations of future profitability.

However, the company’s announcement also contained some good news from management, consisting of sales and gross profit increases, new store openings, and reiteration of expected 26% future earnings growth. Furthermore, second quarter earnings of 37 cents were up considerably, from 26 cents (on a comparable basis) for the second quarter of the previous year.

The fall in Best Buy’s stock price seems consistent with securities market efficiency if we accept that the impact of the bad news outweighed that of the good news.

Note: A good answer will consider at least some items each of bad and good news. Given this, an argument that the good news outweighed the bad, so that the market reaction was not consistent with efficiency, is also acceptable. For example, an acceptable conclusion, if reasonably supported, would be that the market overreacted.

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The negative effects of hurricane Katrina would be of low persistence,

particularly since management states that the store closings were “brief.” Management’s concern about high gasoline prices also suggests low persistence of the earnings increase, since if consumer spending falls, this would reduce future profitability.

However, other events suggest that the earnings increase will persist. These include the increase in sales, particularly same-store sales, the increase in the gross profit ratio, and the opening of additional stores. Furthermore, management has reiterated its guidance of 26% future growth in earnings from continuing operations.

A reasonable conclusion is that the earnings increase is of medium to high persistence.

21.

IBM’s share price dropped because the market had originally been misled

about the persistence of IBM’s earnings. By failing to disclose the nature of the gain, IBM conveyed the impression that it was persistent. Thus, the market reaction to IBM’s current earnings was too high in retrospect. Once the market learned the true nature of the transaction, investors quickly revised downwards their beliefs about IBM’s future performance, in effect lowering the original response. This resulted in a lower share price.

An alternative explanation, equally acceptable, is that once the market learned the true nature of the item, it realized that IBM’s earnings were, in effect, lower than expectations (proxied by analysts’ forecasts) rather than exceeding forecasts by 1 cent. Thus, IBM’s earnings conveyed BN rather than GN, and the share price fell as a result.

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To the extent that the market felt it had originally been misled when IBM earnings were reported as beating analyst forecasts, an increase in estimation risk would also contribute to a fall in share price.

22.

Calculate the expected return on Apple shares for the week ended April 30, 2013:

From the market model, we have Rjt = αj + βRMt = Rf (1 – βj) + βj(RMt) = 0.15/52(1 - .99) + .99(.0204) = 0.0029 × .01 + .99 × .0204 = 0.0000 + .0202 = .0202 Where period t is the week ended April 30, 2013 and RMt = (3,328.79 – 3,262.21)/3,262.21 = 66.58/3262.21 = .0204, where M is the NASDAQ Composite Index. Actual return on Apple for the week was .0902 Abnormal return on Apple shares for the week was thus .0902 - .0202 = .0700, or about 7%

It seems that the equity market reacted favourably to Apple’s bond issue. b.

Reasons why it may be unwise to buy bonds used to finance a share buyback: •

The money raised from the bond issue leaves the company. Thus there is less of a “cushion” of net assets to provide bondholder security. 189 .

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The share buyback may indicate that the company does not have a productive use for additional capital. That is, the proceeds of the bond issue are not used to invest in new capital assets.

•

To the extent that the share buyback is motivated by a desire to increase the firm’s share price, it is possible/likely that share price has been falling. A falling share price may indicate that the firm is heading for financial distress, further increasing the bondholders’ risk.

•

The firm incurs a major new fixed cost (i.e., interest payments). This reduces cash flow available to finance interest and investment. Reasons why it may not be unwise:

•

Low interest rates. Since, as indicated by the low Federal Funds Rate, interest rates in the economy are low, the firm can obtain debt financing at relatively low cost. This reduces the strain on the firm’s cash flow to meet interest payments.

•

While interest rates on the new debt issues are low, they are likely considerably greater than interest rates on risk-free debt due to the low interest rate environment. Since investors are risk averse and thus trade-off risk and return, the rate on the new bonds may be sufficiently high to overcome bondholders’ concerns about the security underlying the bonds.

•

There may be few or no bonds already outstanding. If so, the risks to the new bondholders are reduced.

•

Interest payments are tax deductible, further reducing the strain on cash flow.

A reasonable conclusion is that while the reasons it is unwise to invest in bonds used to finance a share buyback are persuasive in general, the fact that the bond issue was successful suggests that the reasons in favour of investing in Apple bonds dominated the reasons against. The lowinterest rate environment and the size and reputation of Apple Inc. seem to have overcome the concerns. This episode illustrates the saying that “it is the exception that proves the rule.” 190 .

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Additional Problems 5A-1. In 1998, Stelco Inc. announced plans to alter its capital structure by redeeming $99 million par value of its preferred shares at par. The dividend rate on these shares was about 7.75% of par value. Consequently, after the redemption, the portion of net income going to Stelco’s common shareholders will be substantially increased. Explain the impact of this redemption on the ERC of Stelco’s reported net income. 5A-2. In 1991, the AICPA established a Special Committee on Financial Reporting. This committee, made up of several leaders in public accounting, industry, and academe, was charged with reviewing the current financial reporting model and making recommendations on what information management should make available to investors and creditors. In 1994, the Committee made several recommendations in a report entitled “Report of AICPA Special Committee on Financial Reporting” that it argued should help investors and other users to improve their assessment of a firm’s prospects, thereby increasing the decision usefulness of annual reports. Here is one of its recommendations: The Committee recommended that companies differentiate between core activities and non-core activities in their income statement, balance sheet, and cash flow statement. “A company’s core activities—usual and recurring events— provide the best historical data from which users discern trends and relationships and make their predictions about the future.” Non-core activities are defined as “unusual and nonrecurring activities or events (non-core effects) as well as

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interest charges. Without adjustment, non-core effects can distort or mask an important trend or relationship in the company’s ongoing business.” Source: Excerpt reprinted with permission from report of the AICPA Special Committee on Financial Reporting. © 1994 by American Institute of Certified Public Accountants, Inc. Required a.

Use the concept of earnings persistence to explain why the Committee

recommends separate reporting of the results of core activities on the income statement. b.

Why does IAS 1 prohibit the use of the term “extraordinary items” in the

income statement?

Suggested Solutions to Additional Problems 5A-1. This reduction should increase Stelco’s ERC: •

From the standpoint of the common shareholders, preferred shares are like debt since both debt and preferred shares rank prior to the common shares in terms of interest and dividends and return of capital. There is an inverse relationship between the proportion of debt in a firm’s capital structure and its ERC, according to the results of Dhaliwal, Lee and Fargher (1991), and Billings [Billings, B. K., “Revising the Relation Between the Default Risk of Debt and the Earnings Response Coefficient,” The Accounting Review, (October, 1999), pp. 509-522}. The reason is that for a given amount of GN in earnings, more of the GN belongs to the common shareholders when debt is lower, hence the ERC will rise. If the news is BN, there is less debt (here, preferred shares) to help absorb the shock. That is, debt and preferred shares share in the 192 .

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increased default risk that accompanies the BN. The ERC should rise for BN as well. •

A secondary effect is through Stelco’s beta. Since preferred dividends rank ahead of common dividends, a reduction in the preferred dividend requirement will reduce the common shares’ susceptibility to the ups and downs of the economy, that is, its beta will fall. A fall in beta increases the ERC, according to the results of Collins and Kothari (1989) and Easton and Zmijewski (1989). Note: This effect on beta has been demonstrated theoretically by Hamada (1972)–see Section 7.12.

5A-2. a.

Non-core activities are defined as unusual and nonrecurring. Thus, they

have low persistence, by definition. If these items are not identified as such then investors may get an exaggerated impression of the persistence of the GN or BN in income from continuing operations. This will hamper investors’ ability to predict future profitability. b.

One likely reason is that the term “extraordinary item” is somewhat

ambiguous. It is often difficult to determine if a low-persistence component of net income is or is not extraordinary. Consequently, use of the term does not give a clear message to investors of how persistent the item actually is. Another likely reason is that the IASB feels that by requiring full disclosure of low-persistence items in the income statement, investors are protected against hiding items that are in fact extraordinary in core earnings.

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CHAPTER 6 THE MEASUREMENT APPROACH TO DECISION USEFULNESS 6.1

Overview

6.2

Are Securities Markets Fully Efficient? 6.2.1 Introduction 6.2.2 Prospect Theory 6.2.3 Is Beta Dead? 6.2.4 Excess Stock Market Volatility 6.2.5 Stock Market Bubbles 6.2.6 Discussion of Market Efficiency versus Behavioural Finance

6.3

Efficient Securities Market Anomalies

6.4

Limits to Arbitrage*

6.5

A Defence of Average Investor Rationality* 6.5.1 Dropping Rational Expectations 6.5.2 Dropping Common Knowledge

6.6

Summary re Securities market Inefficiencies

6.7

Conclusions About Securities Market Efficiency and Investor Rationality

6.8

Other Reasons Supporting a Measurement Approach

6.9

The Value Relevance of Financial Statement Information 194 .

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Ohlson’s Clean Surplus Theory 6.10.1 Three Formulae for Firm Value 6.10.2 Earnings Persistence 6.10.3 Estimating Firm Value 6.10.4 Empirical Studies of the Clean Surplus Model 6.10.5 Summary

6.11

Auditors’ Legal Liability

6.12

Asymmetry of Investor Losses*

6.13

Conclusions on the Measurement Approach to Decision Usefulness

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

To Understand the Measurement Approach to Financial Reporting

I begin coverage of this chapter with a discussion of what the measurement approach means. In essence, it means the introduction of more forward-looking information into the financial statements proper. Points that I bring out are as follows: (i)

Review the implications of securities market efficiency for financial

reporting, under which it is assumed that the market can quickly digest all available information. The value relevance literature discussed in Chapter 5, by and large, studied the information content of historical cost-based financial statements. The conclusion was that such statements were found to be decision useful since share prices responded in predictable ways to reported net income.

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The question then is, if historical cost-based financial statements are value relevant, why are standard setters moving towards introducing more measurement into accounting standards? (ii)

Review the concept of current value, introduce in Section 1.2, since

current values are more forward-looking than historical costs. As pointed out in that section, with further discussion in Section 7.2, there are two approaches to current value—value-in-use and fair value. (iii)

Tie both current value approaches to the concept of decision usefulness.

That is, given the ample evidence that historical-cost-based net income has information content for investors, why try to "fix" historical cost accounting if it "ain't broken"? An answer is that perhaps decision usefulness can be further increased by building more current values into the financial statements proper, hence into the measurement of earnings. The focus of this chapter is to explore why standard setters have moved towards a measurement approach. (iv)

Don't forget about reliability. If the measurement approach is to enhance

decision usefulness, there must not be a significant reduction in reliability. While RRA is supplementary information, not information in the financial statements proper, it illustrates how forward-looking information can suffer from reliability issues. Also, many cases of premature revenue recognition referred to in Chapter 2 (Problems 12, 14, 25, and 26 of Chapter 2 relate to revenue recognition) resulted from low reliability. I sometimes tie this argument back to the information system (Table 3.2). That is, the ability of accounting information to predict future firm performance will only be enhanced if increased relevance under the measurement approach is not cancelled by reduced reliability, relative to historical-cost-based information. It is the net effect on the main diagonal probabilities of the information system that will govern whether or not fair value accounting increases decision usefulness. 2.

To Appreciate Reasons Why Financial Reporting is Moving in a Measurement Direction 196 .

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The text suggests four reasons why financial reporting is moving in a measurement direction. These are: (i)

Theory and evidence that securities markets may not be as fully efficient

as the value relevance studies reviewed in Chapter 5 assumes. Then, building more current values into the financial statements proper may enable the market to better predict future firm performance. This, of course, is because current values, being primarily future-oriented, are more relevant than historical costs, and, by definition, relevance is the ability to predict future economic performance. (ii)

Low value relevance of financial statement information. This is Lev’s 2

(1989) “low R ” argument. Perhaps the apparent decline in the proportion of abnormal share price variability explained by unexpected earnings can be reversed by introducing more current values into the measurement of income. (iii)

Ohlson’s clean surplus theory. This theory demonstrates that,

theoretically, firm value can be derived from financial statement information just as well as from dividends or cash flows. The derivation starts with balance sheet net worth and adds discounted expected future abnormal earnings. To the extent that the balance sheet is based on current values, there are less future abnormal earnings to predict, since, by definition, current value incorporates expected future value, either by fair value or value-in-use. Thus, other things equal, the better the balance sheet incorporates current values, the better the predictions of firm value. More fundamentally, the demonstration of the equivalence of dividend, cash flow and financial statement-based approaches to firm valuation puts earnings prediction on a firm theoretical basis, leading naturally to a measurement approach. (iv)

Auditor liability. My own view is that much of the pressure for more

measurement in the financial statements proper arises from auditor liability, particularly with respect to the failures of savings and loans financial institutions in the United States during the 1980s and early 1990s. Perhaps greater use of 197 .

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current values in the accounts will better enable the market to anticipate financial distress, thereby reducing the number of auditor lawsuits. I have gone out on a bit of a limb in suggesting these reasons for increased attention by standard setters to measurement issues, since they are speculative on my part. Instructors are urged to challenge them if they do not agree. Certainly, as will be documented in Chapter 7, accounting practice has moved in a measurement direction, although events during the 2007-2008 market meltdowns have resulted in some movement by the IASB from fair value to value-in-use (i.e., amortized cost accounting) accounting for financial instruments—see Chapter 7, Section 7.5.2. The FASB seems somewhat more committed to fair values than the IASB. For example, it is not clear that the FASB will accept the business model concept that the IASB uses to justify amortized cost accounting. Also, the FASB allows more general use of the fair value option than the IASB (Section 7.5.3). However, both bodies are working on a new standard to recognize loan losses sooner than at present. When completed, the new standard will represent a major step in the measurement direction (Section 7.5.4). 3.

To Review Theory and Evidence that Securities Markets May Not be Fully Efficient.

The 2007-2008 market meltdowns have raised serious questions about the efficient market hypothesis. Instructors should discuss at least some, and possibly more, of the behavioural finance theories and evidence underlying these criticisms outlined in Section 6.2. The post-announcement drift and accruals anomalies are some of the strongest evidence questioning investor rationality and market efficiency. My reading of the research on these anomalies is that while we still do not fully understand them, they are slowly yielding to cost- and risk-based explanations (see discussion of limits to arbitrage in Section 6.4 (optional section)). Note that while these anomalies suggest that markets are not fully efficient, they do not necessarily conflict with average investor rationality. 4.

To Defend Market Efficiency Theory and Average Investor Rationality 198 .

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In this edition, I admit that securities markets are not fully efficient. One reason follows from the accruals and post-announcement drift anomalies, which supply convincing evidence that prices do not always fully and immediately react to new information (although this may be due as much to limits to arbitrage as to behavioural biases). A second reason is that the theory can break down at times, such as during the bubble behaviour of security prices during the 2007-2008 market meltdowns. The meltdowns, in particular, have generated considerable criticism of market efficiency theory and investor rationality. I do maintain, however, that except during bubble periods, security prices are sufficiently close to full efficiency that the theory of market efficiency is still the best available theory for accountants to understand the role of information in investment decisions and the economy. Some instructors may wish to discuss these criticisms, particularly since they underlie many of the new standards that are described in Chapter 7. Consequently, Sections 6.5 (optional section), 6.6, and 6.7 contain my argument in favour of the theories. My argument basically is that while securities markets may not be fully efficient, the theory of rational investor behaviour can still be saved. That is, average investor rationality is at least as consistent with observed security price behaviour as are the behavioural theories of investor behaviour. To pursue the argument, if one drops the assumptions of rational expectations and common knowledge that underlie many economic models, such as the CAPM, security price behaviour, such as postannouncement drift, can be explained by models of rational investment. To illustrate, I outline the models of Brav and Heaton (2002) and Allen, Morris, and Shin (2006), and supporting empirical studies, in optional Section 6.5. Interested instructors may also wish to review the discussion of rational expectations and common knowledge assumptions in Section 4.5.2. 4.

To Introduce Ohlson's Clean Surplus Theory

I usually confine my presentation to illustrating how the theory can be used to estimate firm value, following the development in Section 6.10.3 for Canadian Tire Corp., or

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some other well-known firm. On the way through my illustration, however, I bring out relevant aspects of the theory. The following are the major points I bring out. (i)

I treat this theory as providing a demonstration of how firm value can be

expressed in terms of financial statement variables, consistent with the measurement approach. The theory is based on dividends as the fundamental determinant of firm value. Given arbitrage, dividend irrelevance, and risk neutral firm valuation, firm value is also determined by the value of the firm's net balance sheet assets plus the expected present value of its future abnormal earnings (i.e., its goodwill). This is because the value of the firm's net balance sheet assets captures the present value of its future "normal" earnings, and sooner or later all earnings – normal plus abnormal – will be paid out as dividends. (ii)

A fundamental significance of the clean surplus theory is that it roots

financial accounting theory solidly in the theory of value. Instead of having to borrow theories from economics and finance, financial accounting itself contains a theoretically sound valuation benchmark. In this sense, the theory plays a role analogous to the Modigliani-Miller theory in finance. (iii)

Under the simplest version of clean surplus theory (unbiased accounting

and no earnings persistence) the expected present value of future abnormal earnings is zero and, with no persistence of abnormal earnings, the value of the firm is read directly from the balance sheet, as in Example 2.2. (iv)

How do earnings enter into the theory? Given the wealth of evidence in

Chapter 5 that the securities market responds to earnings, the theory seems incomplete if earnings play no valuation role. When accounting is unbiased, they do not play a role, since all value appears on the balance sheet (i.e., unrecorded goodwill is zero) However, when earnings lag real economic performance (biased accounting), expected abnormal earnings are the basis for estimating unrecorded goodwill. This is illustrated in the latter part of Section 6.10.1 by assuming the firm uses straight line, rather than economic, amortization. In the example, straight line lags economic depreciation. 200 .

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When the use of the clean surplus model to estimate firm value is applied to Canadian Tire in 2012, the firm’s actual share price is considerably less than the clean surplus estimate. The text goes into considerable soul-searching at this point. One point to bring out is the assumption in Section 6.10.3 that Canadian Tire’s abnormal earnings will continue at their present rate for seven years and then fall to zero. Obviously, a variety of other assumptions can be made, as discussed in the text. The important point, however, is that prediction of future earnings is the most critical aspect of the application of the theory to valuation. The length of time during which abnormal earnings will persist depends on how successful the firm is in staving off the competition that is inevitably attracted to the presence of abnormal earnings. The answer ultimately depends on the firm’s business strategy, a topic beyond the scope of this text. After this soul searching, the text concludes that the main reason for the discrepancy is that analyst forecasts are for a decline in future profitability of Canadian Tire, due to increasing competition, a conclusion that is consistent with reasonable market efficiency. For instructors who wish to pursue clean surplus theory in greater depth, Section 6.10.2 gives a simplified version of the Feltham and Ohlson earnings dynamic. The persistence parameter ω of the earnings dynamic specifies a linkage between current and future abnormal earnings. Thus, according to the theory, the market looks to the income statement for the current realization of abnormal earnings, consistent with the empirical evidence of the impact of earnings on share price given in Chapter 5. If the accounting is biased, as under the historical-cost basis, the income statement assumes still greater relevance since it then also indicates how much of the bias of bvt is realized in the current period. The parameter νt-1 captures the impact on future earnings of events in year t-1 that are not recognized in net income of year t-1. Other examples of how additional information can be used to refine estimates of future earnings are discussed in Section 6.10.4. See Abarbanell and Bushee (1997) re “fundamental signals” from the balance sheet, and Begley and Feltham (2001) re capital expenditures.

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Note that earnings can be predicted using analysts’ forecasts, instead of by means of the earnings dynamic. This is discussed in Sections 6.10.3 and 6.10.4. For instructors who wish to dig more deeply into the use of the earnings dynamic versus analysts’ forecasts in predicting earnings, see the paper of Courteau, Kao and Richardson (2001) referenced in Section 6.10.4. Most students find an assignment requiring them to use the clean surplus model to estimate firm value and compare with actual share price to be quite interesting. The Canadian Tire example in Section 6.10.3 provides a template. See also C.M.C. Lee, “Measuring Wealth,” in CA Magazine (April, 1996), pp. 32-37. The Canadian Tire example in the text is based on the procedure outlined in Lee. When working on this assignments, students often use the previous year’s return on the market as an estimate of the expected return on the market needed to apply the CAPM. However, this approach is problematic, especially if the previous year’s market return is negative. The concept of market risk premium, that is, the extra return over the risk free rate demanded by the market to invest in risky equities, provides another way to estimate the expected return on the market. See Note 39 of chapter 6 re the market risk premium. For a brief outline of how to apply the market risk premium in a CAPM context see Bernard, Healy and Palepu, Business Analysis and Valuation, second edition (Cincinnati, Ohio: South-Western College Publishing, 2000), pp. 12-14 to 12-16. 5.

To Appreciate how Auditor Legal Liability leads to Conservative

Accounting Section 6.11 outlines the famous, or infamous, Savings and Loan debacle of the 1980s and 1990s, which led to large auditor liabilities. This incident demonstrated a “fatal flaw” in historical cost accounting that enabled financial institutions to conceal approaching financial distress, and was instrumental in leading to the development of impairment tests for most assets. The section also includes an introduction to the concepts of conditional and unconditional conservatism, including the well-known Basu (1997) paper that developed a market-based measure of conditional conservatism. Recall that this text views conservatism as a partial application of the measurement approach. 202 .

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For instructors who may wish to dig somewhat deeper into conservatism as a reaction to auditor liability, Section 6.12 (optional section) develops a legal liability motivation for conservatism due to the asymmetry of utility loss suffered by a risk averse investor. That is, such an investor loses more utility from a wealth overstatement than an understatement of the same amount. If so, a downwardly biased (i.e., conservative) valuation of net assets leads to greater investor expected utility than an unbiased (i.e., current value) valuation. Downwardly-biased valuations thus contribute to reducing auditor liability because downward biasing reduces the likelihood that there will be an overstatement error, and it is overstatement errors, rather than understatements that usually lead to lawsuits against auditors. This argument is demonstrated using an elaboration of the single-person decision theory illustrated in Section 3.3. In the process, the distinction between conditional and unconditional conservatism is brought out.

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

The following reasons for a measurement approach are suggested: •

It appears that historical cost-based net income explains only about 2–7% of the variability of share prices around the time of earnings announcement. This is Lev's (1989) "low R2" argument. Introducing more value-relevant information into the financial statements proper may increase earnings quality, assuming reasonable reliability, and thus increase the "market share" of net income.

•

Evidence from behavioural finance, in particular the PAD and accruals efficient securities market anomalies, suggests that investors need more help in interpreting earnings based on historical costs, together with supplemental disclosur, than previously assumed. Incorporating more value-relevant information into the financial statements proper may be a way to do this.

•

Perhaps the introduction of more value-relevant information into the financial statements will reduce auditors' legal liability, since the auditors can then better argue that the financial statements anticipated the changes in value that led to legal liability. This is particularly the case for overstatements of value. Overstatements can be reduced by conservative accounting in the financial statements proper, such as impairment tests.

•

Ohlson's clean surplus theory provides a theoretical framework supportive of a measurement approach. Better measurement of assets and liabilities reduces the pressure on forecasts of future abnormal earnings when using the clean surplus model to predict firm value.

Adoption of a measurement approach will increase the relevance of financial statement information. Relevant information is information that enables users to evaluate the firm’s future performance. The measurement approach implies the use of current values of assets and liabilities, such as fair value (if markets work 204 .

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well, market price today is the best estimate of value tomorrow) and value-in-use (discounted future expected cash flows). Consequently, this approach is more relevant than valuations based on historical cost. Assuming that reasonably well-working markets are available, a measurement approach should not reduce reliability. In terms of the Conceptual Framework, such values are representationally faithful. That is, they are a complete, errorfree, and unbiased representation of the real value of the item being valued. However, if well-working market values are not available, estimates of fair value must be made, and such estimates imply lower reliability. Note: Levels 1, 2 and 3 of the fair value hierarchy, discussed in Section 7.2, could be introduced here. The effect of the measurement approach on decision usefulness depends on its relative effects on relevance and reliability. If the main diagonal probabilities of the information system increase due to higher relevance by more than they decrease due to lower reliability, decision usefulness of the financial statements proper will increase. 3.

Reasons why prospect theory predicts that security prices will differ from

their prices under efficient securities market theory: •

•

Disposition effect. This arises from the Prospect Theory assumption of loss aversion, under which investors dislike even a small loss more that they like a small gain of equivalent magnitude. As a result, investors tend to hold on to losers and sell winners. If investors hold on to loser (i.e., bad news) securities, their market prices will not fall as much as is predicted under market efficiency. Under- or over-weighting of probabilities. If investors under- or overweight their probabilities of future firm performance relative to posterior probabilities under Bayes’ theorem then, unlike rational investors, they are not fully utilizing all available information. As a result, security prices will depart from their efficient market values.

Two accounting-related efficient securities market anomalies are: •

Post-announcement drift. When firms report good or bad news in earnings, security prices take time to fully respond to this 205 .

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information. That is, they drift up and down following good and bad news in the earnings announcement. This is an anomaly because under securities market efficiency security prices should respond very quickly to the full information content of reported earnings. Note: An alternative answer, equally acceptable, is that under postannouncement drift, changes in security prices are positively serially correlated. Under efficient securities market theory, security price changes are serially uncorrelated. •

Accruals anomaly. Net income can be decomposed into operating cash flow plus or minus net accruals. Accruals are less persistent than operating cash flows since they reverse. Also, accruals are more subject to errors of estimation and possible manager bias than cash flows. Since errors and bias tend to reverse quickly, they further reduce persistence. The accrual anomaly is that while security prices respond to net income, they do not seem to respond to the proportion of accruals to operating cash flows in that net income. This is an anomaly because under securities market efficiency, the abnormal return and ERC on a firm’s shares following an earnings report should be less the greater the proportion of accruals in earnings, since accruals are less persistent.

Behavioural characteristics that predict underreaction to the full information content of financial statements include: •

•

Conservatism: Under conservatism, investors under-weight new evidence relative to the weight they should place on it under Bayes’ theorem. The resulting excess weight on their prior beliefs means that share prices under-react to new information relative to the reaction under market efficiency. Limited attention. Investors subject to limited attention do not bother to process all the information available to them. In an accounting context, they may ignore supplemental information such as RRA, notes disclosures, and MD&A. As a result, share prices under-react to all information, relative to an efficient market reaction under which the location or form of information does not matter. Narrow framing, leading to the disposition effect of prospect theory, under which investors are more likely to hold on to loser securities relative to winners. This leads to share price under-reaction to accounting information. If a firm reports bad news and investors do not sell, share price will be lower than the price that would result under market efficiency.

Note: Any two characteristics are acceptable. 206 .

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To the contrary. To the extent that investors are behaviourally biased, the importance of high quality reporting increases, since better reporting can help to reduce the share mispricing that such biases produce. Reporting improvements that can help reduce biases include moving information from financial statement notes to the financial statements proper, full and clear reporting of low-persistence items, and high quality MD&A and risk disclosures. As a result, share prices are closer to fundamental value, and society benefits from better-working capital markets.

Post-announcement drift is the tendency for the share prices of firms that report GN or BN in quarterly earnings to drift upwards and downwards, respectively, for a lengthy period of time following the release of the earnings report. It is known that quarterly seasonal earnings changes are positively correlated. The reporting of, say, GN this quarter (compared with the same quarter last year) increases the probability of reporting GN next quarter as well. Thus, current quarterly earnings have two components of information content. One component is their information content per se—they provide current GN or BN that enables investors to revise their beliefs about future firm performance. Second, they increase the probability of GN or BN in future quarters, which will enable a further belief revision. This is an anomaly for efficient securities markets theory because, to the extent that the drift is not explained by barriers to arbitrage such as idiosyncratic risk or transactions costs, share prices should respond quickly to all the information content of earnings, according to the theory. However, this does not seem to happen. Instead, the market takes a lengthy period of time to figure this out or, alternatively, it waits until the current implications are validated in subsequent quarterly reports. Post announcement drift could be driven by behavioural biases such as conservatism or limited attention.

The efficient market will respond more strongly to the GN or BN in earnings (i.e., a higher ERC) the greater is the persistence of the GN or BN. Cash flows are 207 .

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more persistent than accruals since accruals are more subject to errors of estimation and possible manager bias than cash flows, thereby reducing the association between current accruals and next period’s net income and speeding up accrual reversal. Operating cash flows are not subject to this reversal phenomenon. Sloan checked this argument for his sample firms and found that cash flows were indeed more persistent than accruals. This being the case, an efficient market will respond more strongly to a dollar of abnormal earnings if it comes from operating cash flows than if it comes from accruals (recall that net income equals operating cash flows plus or minus net accruals). Sloan found that while the market did respond to the GN or BN in earnings, it did not respond more strongly when there was a greater proportion of cash flows to accruals in earnings. This is an anomaly because efficient securities market theory predicts a lower security market response the greater is the proportion of accruals in net income. 6.

According to rational single-person decision theory, the investor will likely

prefer the first fund, since it has both a higher expected return and a lower standard deviation of return. Note: In assessing risk, the investor may be attracted to the second fund because of its guarantee of no negative return. This guarantee becomes more attractive the more risk averse the investor. However, the attractiveness of the lower standard deviation of the first fund also becomes more attractive. Thus, the effect of the guarantee on the investor is unclear. The most likely outcome is that he/she buys the first fund. b.

According to prospect theory, however, investors will separately evaluate

gains and losses on their investment prospects, and the rate of decrease of utility for small losses may be considerably greater than the rate of increase of utility from small gains. Since the second fund truncates the fund losses, this gives it an advantage over the first fund.

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Also, under prospect theory, investors may underweight probabilities of states that are likely to happen, as a result of overconfidence bias, and overweight probabilities of states that are unlikely to happen, due to representativeness bias. The probability of a gain on the first fund is high relative to the probability of a gain on the second fund (due to higher expected return and lower standard deviation of the first fund). Thus, underweighting the high probability of a gain on the first fund and overweighting the low probability of a gain on the second fund tilts the decision towards the second fund. Thus, the choice of the second fund is due to either or both of a relatively high disutility for losses and weighting of probabilities. 7.

Earnings quality, also called informativeness of the information system, is

the ability of current earnings to enable investors to predict future firm performance. It can be conceptualized by the main diagonal probabilities of the information system (Table 3-2). The higher the main diagonal probabilities relative to the off-main diagonal, the greater the quality. b.

Reasons why earnings quality may be low: •

Recognition lag. Due to concerns about reliability, net income lags in recognizing many value relevant events. Thus costs such as research and advertising are expensed during the period, even though they will likely generate future cash flows. Unless the increase in reliability from writing off such costs outweighs the decrease in relevance, recognition lag reduces the ability of net income to predict future firm performance.

•

Low accruals quality. To the extent that accruals are of low quality (due to low persistence resulting from possible error and manager bias), the ability of net income to predict future firm performance is reduced.

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Poor disclosure. Poor disclosure may prevent investors from fully evaluating earnings persistence, thereby reducing the ability of net income to predict future firm performance.

•

Estimation risk. To the extent that net income omits inside information, the ability of net income to predict future firm performance is reduced. Investor concern about the possibility of insiders exploiting their inside information advantage reduces their reaction to reported net income.

Increased use of a measurement approach in financial statements will

raise earnings quality if the resulting increase in relevance outweighs the decrease in reliability. Relevance increases because there is less of a lag in recognition in net income of value-relevant events such as changes in fair values of investments and capital assets, changes in the present value of long-term debt, successful research, etc. Reliability will not decrease providing fair values are based on well-working market prices. However, to the extent such market values are not available, greater use of measurement requires estimation, which will decrease reliability due to the possibility of error and manager bias. If the effect on relevance is greater than the effect on reliability, the main diagonal probabilities of the information system increase. That is, earnings quality increases. Then, we would see a larger response of security prices to the good or bad news in earnings (i.e., higher ERC). 8.

From a single person decision theory perspective, reported earnings are value relevant if they lead to buy/sell decisions, as investors revise their beliefs about future firm performance during a narrow window surrounding the date of release of the earnings information. These buy/sell decisions in turn lead to rapid changes in share prices and returns. R2 measures value relevance of earnings information since it is the proportion of the variability of abnormal share return explained by the GN or BN in reported earnings during a narrow window surrounding the earnings release date—the 210 .

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higher is R2 the greater the value relevance of reported earnings since, by the definition of R2, a greater proportion of the change in share price during the narrow window is then explained by the earnings information. ERC also measures value relevance of earnings information since it is the amount of abnormal share return per dollar of earnings’ GN or BN. The greater is the value relevance of reported earnings the higher is the ERC, since high value relevance (high information system main diagonal probabilities) increases the weight of net income (relative to prior beliefs) in investors’ posterior beliefs (via Bayes’ theorem). That is, with high value relevance, most investors will increase their posterior probabilities of good future firm performance if earnings are GN, thereby triggering buy decisions and resulting share price increase, and vice versa for BN. Thus, the higher is value relevance, the higher is the ERC. 2

Yes, it is possible for R and ERC to fall but abnormal return to increase if other, favourable, firm-specific information accompanies the earnings announcement. Abnormal return includes the effects of all firm-specific factors affecting share 2

price, while R and ERC capture only the effects of reported earnings. Other firm-specific information which may accompany the earnings announcement includes announcements and forward-looking information from company officials, information on unusual and non-recurring events, analysts’ comments, and media articles. This information will also affect buy/sell decisions. Thus if it is sufficiently favourable, it can increase abnormal return even though R2 and ERC fall. 9.

The word “rational” may have been dropped due to theory and evidence

from behavioural finance, which suggests that investors on average are not fully rational and securities markets are not fully efficient. Alternatively, the word may have been dropped because standard setters feel that it goes without saying that they want to encourage rational decisions, not irrational ones. That is, the word may be redundant.

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If investors do not make rational decisions, the role of financial reporting in

providing useful information to investors is increased. Since investors subject to behavioural biases may ignore or distort financial information, it can no longer be assumed that they will fully incorporate all available information into securities price regardless of source. Then, the location, understandability, and comparability of information become important. To the extent that high quality financial statement information makes it easier for behaviourally biased investors to overcome their biases, their investment decisions will be improved. c.

Relevant information gives investors information about the firm’s future

economic prospects. Reliable information faithfully represents what it is intended to represent. To do so, it must be complete, free from material error, and neutral, where neutral information is free from any bias which may affect its interpretation by the user Both increased relevance and increased reliability increase the main diagonal probabilities of the information system, and vice versa. When conditions are not ideal, these qualities have to be traded off because attaining greater relevance requires more predictions of future events (states of nature). However, predictions require estimates. Since the assumptions and conditions underlying estimates may change, and since estimates are subject to error and possible manager bias, relevant information may not faithfully represent what it is intended to represent. That is, increasing the relevance of information reduces reliability.

10.

Transactions costs. To the extent there are costs to exploit securities market inefficiencies, investors will not fully eliminate share mispricing through arbitrage. This allows anomalies such as post-announcement drift and the accruals anomaly to continue. Idiosyncratic risk. To exploit market anomalies, investors must depart from a strategy of portfolio diversification. Then, firm specific risk becomes a larger 212 .

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component of the investment portfolio. Since risk averse investors trade-off risk and return, increased risk inhibits their investments in mispriced securities. This allows the anomalies to continue. 11.

According to clean surplus theory, the firm’s opening market value is:

PA1 = Book value + present value of exp ected future abnormal earnings (100 − .12 × 600) 1.12 28 = 600 + = $625.00 1.12 = 600 +

Note: Many students answer this question as $600 + 100/1.12 = $689.29. This is incorrect as it ignores the fact that firm value consists of net assets as per the balance sheet plus the discounted present value of expected future abnormal earnings (i.e., goodwill). Goodwill is the ability of the firm to earn more than cost of capital on the net book value of its assets. Failure to deduct a capital charge overstates firm value, since the market expects the firm to earn its cost of capital on opening investment. If the firm earned only cost of capital on its net assets, its market value would be $600. 12.

I have used this assignment on numerous occasions. Most students seem to enjoy it. I find that application of the “recipe” to value Canadian Tire Corp. in Section 6.5.3 is usually well done, although the instructor may assist students to evaluate the expected return on the market by discussing the concept of market risk premium described in Note 39 of this chapter. Stocks’ betas are usually available on the internet—Reuters and Yahoo Finance are good sources. If not, it is relatively straightforward to estimate beta directly, based on the formula given in Section 4.5 and 25 or more days of data. A complication is that many Canadian firms have a dual common share structure—see Note 40. While rather ad hoc, I suggest simply adding the number of shares of each class.

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The main problem students have with this assignment is to see beyond simply applying the procedure. Consequently, an important part of the assignment is to consider the effect of recognition lag, such as for R&D, on the calculations, to consider the pattern and length of time that abnormal earnings are expected to persist, and consider any analyst forecasts. In my opinion, the main reason that the estimated share value often differs substantially from actual market share price is that the market has greater or lesser expectations about the amounts and duration of abnormal earnings than the horizon used in the analysis (I use a 7 year constant horizon for Canadian Tire, with no abnormal earnings beyond 7 years), possibly because of analyst forecasts. I recommend discussing with the students (I do it after the graded assignment is handed back) issues surrounding the assumptions about abnormal earnings, although in an undergraduate course I do not go into the terminal value problem of estimating firm value beyond the specific earnings forecast horizon. 13.

Note: This problem could be considered in conjunction with Problem 12 of Chapter 11 (Nortel). See also Theory in Practice 11.3 (Olympus). Your decision is whether or not to go along with management’s request. Reasons to go along: •

If you do not go along, you may suffer demotion or be fired, or be forced to resign. In contrast, if you go along, you will possibly earn management’s approval and consequent rewards.

•

Recognizing revenue early increases earnings relevance, since investors get an earlier reading on future firm performance.

•

If business picks up next year, the early revenue recognition this year may never be noticed, since reduced revenue recognized next year (as current year’s revenue accruals reverse) will be outweighed by revenue from new business.

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Since GAAP requires considerable judgement in its application, other expert accountants and auditors may conclude that, despite your reservations, the extra revenue recognition does not really violate GAAP under the circumstances.

•

If the auditor goes along with management’s request, you can blame the auditor should the early revenue recognition be discovered.

Reasons to not go along: •

Deliberate GAAP violation is unethical. If discovered, this will lower your reputation, the reputation of management and the company. Investors will lose confidence and share price will fall. You, and other senior management, may be fired by the Board of Directors.

•

If you go along, management’s opinion of you may actually decline. You could be viewed as easily manipulated and of low standards. This would increase the likelihood of similar demands in future.

•

Early revenue recognition lowers earnings reliability. There is a substantial probability that actual earnings on the contracts in process will differ from the amounts currently projected.

•

Management’s optimism may prove to be unfounded, and next year’s business may not pick up. This increases the probability that the early revenue recognition this year will be discovered.

•

Should the auditor not go along, you, management, and the company will become involved in extensive arguments and negotiations with the auditor. This will be costly, time-consuming, and may lead to auditor resignation or a qualified audit report, with attendant bad publicity.

14.

An auditor might be tempted to “cave in” to client pressure to manage

earnings for the following reasons: 215 .

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GAAP are often vague and flexible about specific accounting procedures. For example, there is considerable flexibility with respect to revenue recognition, the useful life of capital assets, and provisions for future liabilities such as site restoration. Such procedures are subject to estimation errors and management bias, hence unreliable. While vagueness and flexibility can be used to report higher current earnings, this comes at the expense of earnings in subsequent years, since accruals reverse. Nevertheless, the auditor may feel that such tactics are acceptable if they do not violate the letter of GAAP.

•

Efficient securities market theory implies that information in MD&A or in notes to the financial statements will be fully incorporated into share prices. Then, the auditor may feel he/she is “off the hook” if these contain information that allows the market to detect and evaluate earnings management policies in the financial statements proper.

•

The auditor may feel that he/she will lose future audit and other business from the client firm if management’s pressure is not accepted.

Longer-run costs to the auditor who yields to client pressure include: •

Lawsuits, when vague and misleading information in the financial statements becomes known.

•

Reduction in reputation, when vague and misleading information in the financial statements becomes known.

•

Reduced public confidence in financial reporting, leading to a loss of business. Since audits will be perceived as less valuable by investors, firms in general will reduce the amount of auditing they engage—why pay the same audit fees if the audit product is not as valuable?

•

Reduced public confidence in financial reporting, leading to increased regulation such as Sarbanes/ Oxley (see Section 1.2). One result of such

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regulation is a reduction in the types of non-audit work the auditor can undertake for the audit client. Note: Increased regulation can also have benefits for the auditor. For example, a provision of the Sarbanes/Oxley Act is that management must certify the fairness of the financial statements. Also, Section 404 of the Act (now relaxed somewhat—see Chapter 13, Problem 15) required management to certify the adequacy of the company’s internal controls over financial reporting. Management needed increased audit work, including examination of internal controls, before signing such a certification. Another benefit, arguably, is that the Act increases the auditor’s ability to stand up to management. This is due, for example to the requirements under the Act that the auditor reports to the audit committee rather than to management, and that the audit committee be composed of independent directors. In addition, the Act creates the Public Company Accounting Oversight Board. This agency has the power to set auditing standards and to inspect and discipline auditors of public companies. If it operates as it should, future reporting scandals and resulting lawsuits will be reduced. b.

To the extent that current values are determined by fair value on properly

working markets, client pressure would likely be reduced, since it is difficult for management to manage or bias market prices. If current values are determined by means of value-in-use measures such as present value, client pressure would remain since numerous estimates are required. The auditor may have little alternative than to accept many of these estimates. Current values, including impairment tests, are future oriented relative to historical cost values. Thus, declines in current values, which typically precede business failure, would be contained in the financial statements proper under the measurement approach (and also under conditional and unconditional conservatism—Section 6.11). This would reduce auditor exposure to lawsuits 217 .

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since the auditor could claim that information predicting a business failure was included in the balance sheet and income statement rather than in the notes, and thus less subject to being missed by ordinary investors and investors with limited attention or other behavioural characteristics. This argument is strengthened by theoretical arguments that risk averse investors suffer a greater loss of utility from asset overstatements than understatements. (This point based on optional reading (Examples 6.3 and 6.4)) c.

Behavioural concepts leading to market overreaction to changes in

earnings expectations include self-attribution bias, representativeness, and overconfidence. Self-attribution bias causes investors’ faith in their investment ability to rise following GN in earnings, leading to the purchase of more shares and development of share price momentum. Momentum is reinforced by positive feedback investors, who buy when share price starts to rise, and vice versa. If earnings are BN, self-attribution biased investors do not lose faith in their investment ability, in which case they would likely hold. If so, the market would underreact to the BN. Thus self-attribution bias as a source of overreaction seems only to operate for GN. Investors subject to representativeness assign too much weight to current evidence, such as earnings growth. Then, the market will overreact to GN or BN in earnings. Overconfident investors overestimate the precision of information they collect themselves, such as financial statement information. Then, if the firm reports GN or BN, they revise their probability of future firm performance by more than they should according to Bayes’ theorem. This leads to share price overreaction to the GN or BN. Market overreaction to BN in earnings may also result according to prospect theory. Under this theory, a reduction in prospects for future earnings lowers investor utility by more than it is increased by a corresponding increase in 218 .

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prospects. Then, we would expect a relatively strong market reaction if earnings forecasts are not met. Since, in effect, investors have suffered a reduction in their wealth. However, prospect theory also predicts that investors will tend to hold on to ”loser” stocks. This would tend to reduce, rather than increase, market reaction to a reduction in earnings expectations. Thus, the extent to which investor behaviour according to prospect theory accounts for market overreaction to BN is not clear. d.

It is difficult to fully evaluate consistency with securities market efficiency

without information on the risk-free interest rate, Kodak’s beta, and the performance of the market index on the day of Kodak’s announcement. Share price did fall after the bad-news announcement, but we cannot tell whether or not the fall is more or less than what would be expected due to market-wide factors on that day. However, if we assume that market-wide effects were relatively small, note that analysts’ estimates of Kodak’s earnings per share fell by .10/.90 = 11.1%. Kodak’s share price fell by 9.25/(79. + 9.25) = 10.5%. Given that investors use current earnings to revise their probabilities of future earnings, hence of future firm performance, the reduction in Kodak’s share price seems reasonable, hence not seriously inconsistent with securities market efficiency. However, share price subsequently rose by 2.25/73.12 = 3% following a .01/.80 = 1.25% excess of reported EPS over analysts’ estimates. This seems less consistent with efficient securities market theory. Note: if sufficient information was given, the market model-based procedure of Chapter 5 would be preferable to analyze market reaction. Also, the present approximation ignores investors’ prior probabilities. Furthermore, the strength of market reaction would depend on Kodak’s earnings quality. If quality was, say, very high, we would expect a stronger market reaction than if quality was low. 15.

Implications of the 2007-2008 market meltdowns for accountants include:

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• Transparency. Financial information should be transparent. Then, investors will find the information useful for decision-making. Financial instruments such as mortgage-backed securities lacked transparency since investors were unable to determine the quality of the underlying individual mortgages, hence the quality of the ABS. Thus, as concern about mortgage defaults increased in years leading up to 2007, investors stopped buying any of them since they could not distinguish the bad from the good.. That is, the market collapsed. Accountants could have prevented the collapse, or at least reduced its severity, by better disclosure of the components of these mortgage-backed securities. • Off-balance sheet activities. By meeting the letter but not the spirit of financial accounting standards, many financial institutions were able to avoid consolidation of off-balance sheet entities that held large amounts of mortgage-backed securities and related financial instruments. Many of these off-balance sheet entities were highly levered. Sponsors of these entities usually gave explicit or implicit warranties that they would take back these securities should the entity fail. As a result, the financial statements of sponsoring financial institutions failed to reveal the full riskiness of their operations. Accountants should improve financial accounting standards to make it more difficult to avoid consolidation of related entities. • Fair value accounting. Accounting standards require many financial instruments to be valued at fair value (i.e., market value). As the markets for mortgage-backed securities and related financial instruments collapsed, huge writedowns were required that destroyed investor confidence in financial institutions and threatened their capital adequacy requirements. These writedowns were criticised by management, who felt that distressed market values (liquidity pricing) understated the future cash flows of financial assets if they were held to maturity. Accountants came under severe pressure from management, and governments, to remedy 220 .

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this situation. Accountants should consider allowing value-in-use accounting for financial instruments when reasonably well-working market values are not available. Note: Accountants are allowing increased use of value-in-use for financial instruments, particularly under IASB standards. See Sections 7.5.1 and 7.5.2, especially re IFRS 9. 16.

The calculation of economic profit by TD is related to the estimation of

firm value under clean surplus theory since they both involve the deduction of a cost of capital charge from reported earnings, to arrive at abnormal earnings. They differ, however, in the time periods to which they apply. Under the TD economic profit approach, abnormal earnings are reported only for the current period. The net assets representing these earnings will be included in TD’s 2005 balance sheet. Under clean surplus theory, it is expected future abnormal earnings that are calculated, and added to current net balance sheet assets. Since TD does not predict its future abnormal earnings, the relationship between its calculation and clean surplus is rather distant. Note: Some students may question the adding back of goodwill/amortization of intangibles to date to invested capital for purposes of the economic profit calculation. The likely reason for adding back goodwill/intangible amortization to date to invested capital is that that the bank regards income before amortization of goodwill and intangibles as better measuring bank performance. Thus it adds amortization back to economic income. But if goodwill and intangibles are not amortized, the cost of these items must be regarded as part of capital, for consistency.

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Note that only amortization of intangibles (i.e., not amortization of goodwill) is added back to economic income. This is because accounting standard setters have eliminated amortization of goodwill (Section 7.11.2). Thus there is only amortization of other intangibles charged against income in 2005. All previous intangible amortization is added back to capital, however. This addback includes goodwill amortized prior to the date of elimination of goodwill amortization. b.

It is likely that TD has unrecorded goodwill. Its ability to earn more than its

cost of capital in 2005 suggests that it does. However, unrecorded goodwill exists only if future abnormal earnings are positive. TD has not estimated these. We may conclude that TD has unrecorded goodwill if it is able to continue earning more than its cost of capital. c.

Either earnings number can be regarded as more useful.

Arguments that net income is more useful include: •

Investors can estimate cost of capital and economic profit for themselves. They have no need for a second profitability measure.

•

There is no GAAP for calculation of economic income. TD has added back amortization of intangibles to capital and added current year’s amortization and items of note to economic income. There is no guarantee that other firms reporting economic income would do the same thing. This affects the comparability of economic income across firms.

•

One can question TD’s assertion that items of note, such as losses on derivatives, preferred share redemption costs, etc. are not indicative of manager performance. Net income includes these items, and as such is a more comprehensive measure of management performance. 222 .

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The capital charge is based on the CAPM. This ignores estimation risk. Then, cost of capital is understated and economic income is overstated. This may give investors an exaggerated impression of TD’s abnormal earning power.

Arguments that economic income is more useful include: •

TD may have a better estimate of its own cost of capital than investors (although this seems unlikely since it is estimated using the CAPM). Then, economic income is useful because it improves the information available to the market.

•

To the extent that investors have limited attention, economic income may be more useful since it removes the need for them to make their own calculations. As a result, such investors will have a better evaluation of firm performance than if only net income is reported.

•

Items of note may have low persistence. Then, ignoring them may improve investors’ ability to predict future firm performance.

Focusing on economic income, either construct may be argued as more useful: If economic income before intangible amortization and items of note is argued as more useful, a reason follows from management’s view that intangible amortization and items of note do not reflect underlying bank performance. This suggests that management believes they are of low persistence. Since it is underlying performance that will largely determine the bank’s future earnings and share price, economic income before intangible amortization and items of note may be more useful to investors who wish to predict future firm performance. If economic income after intangible amortization and items of note is regarded as more useful, a reason is that intangible amortization and items of note are valid expense items and are likely to recur. For example, management has paid for 223 .

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goodwill and other intangibles arising from acquisition of subsidiary companies, and may well acquire other subsidiaries in future. Earnings should bear any resulting amortization and impairment test writedown expense. Also, while the items of note may be of low persistence, similar items are likely to arise in future. Consequently, they should be taken into account when predicting future firm performance. 17:

This is an issue of relevance versus reliability. New Century’s policy is

more relevant than the alternative, since recording the (net of allowance for credit losses) revenue as mortgages are sold and transferred provides an earlier reading on future cash receipts and firm performance. However, this policy is less reliable since the allowance for credit losses on mortgage buybacks has to be estimated, and is subject to error and possible manager bias. The answer thus depends on whether the benefits of early revenue recognition exceed the dangers of lower reliability. In retrospect, the reliability issue dominates, since New Century’s allowance for credit losses of $13.9 million was much too low. However, given the buoyant housing market at the time, it may be that New Century’s management felt that this amount of allowance was adequate. Alternatively, management may have biased the allowance downwards deliberately to maximize reported earnings and share price. The more conservative alternative policy would have avoided this problem of inadequate allowance, since no revenue would be recognized until the warranty period expired. If a mortgage had to be bought back, the full amount of the loss would be recorded at that time—no allowance provision would be needed. A reasonable answer is that one should not agree with New Century’s policy, since both management and the auditor were forced to pay substantial settlements. This suggests deliberate management bias of the allowance amount. 224 .

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At the risk of being naïve, some sympathy for management and auditor may perhaps be warranted, since it is possible that they were caught up in the general optimism about the housing market at the time and honestly believed that their accounting was most decision useful to investors. b.

Again, this is an issue of relevance versus reliability. Since New Century’s

policy of valuing retained interests and service rights at value-in-use is clearly more relevant than waiting to record revenues as cash is received. However value-in-use is less reliable since future cash flows, particularly for retained interests, have to be estimated, and a discount rate chosen. An alternative current valuation of retained interests is fair value. Presumably, fai value was even more subject to reliability problems, since it is unlikely that a wellworking market value for retained interests existed. Since both retained interests and service rights would be backed up by contracts, the value-in-use should be reasonably reliable (while these assets would be subject to economy-wide risk, volatility due to risk is not the same as low reliability). A reasonable answer is to agree with the company’s policy. c.

Yes. A more conservative allowance policy would be to record a higher

buyback allowance. The more conservative the provision for credit losses on buybacks, the lower are reported earnings and the less likely that New Century would recognize huge losses as the market deteriorated. This would have lowered the likelihood that the company have to file for bankruptcy protection, other things equal. Even if New Century did file for protection, KPMG’s argument that the provision was adequate would be bolstered by a more conservative valuation. That is, the more conservative the valuation, the less likely it is that firm profits and value will turn out to have been overstated. For risk averse investors, an overstatement creates greater utility losses than an equal amount of understatement. Thus auditors are more likely to be sued for overstatements of earnings than understatements.

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Additional Problems 6A-1. On January 26, 1995, The Wall Street Journal reported that Compaq Computer Corp. posted record 1994 fourth-quarter results. Despite $20.5 million in losses from the December, 1993, Mexican currency devaluation, and losses on currency hedging, earnings grew to $0.90 per share from $0.58 in the same quarter of 1993, on a revenue growth of 48%. Furthermore, Compaq captured the No. 1 market share spot, with shipments up 50% from 1993 and with slightly higher profit margin. Nevertheless, on the same day, Compaq’s share price fell by $5.00, a decline of about 12%. The Journal reported that analysts had been expecting earnings of about $0.95 per share. Also, there were concerns about Compaq’s scheduled introduction of new products in March 1995, following a warning by Compaq’s CEO Eckhard Feiffer that first-quarter, 1995 earnings were likely to be “flat.” Required a.

Use single-person decision theory and efficient securities market theory to

explain why the market price fell. b.

Assume that the $20.5 million in losses from peso devaluation and

currency hedging are a provision (i.e., an accrual), not a realized cash loss, at the end of the fourth quarter. Use the anomalous securities market results of Sloan (1996) to explain why the market price fell. c.

The Journal quoted an analyst as stating “the market overreacted.” Use

prospect theory to explain why the market might overreact to less-than-expected earnings news. d.

Which of the above three explanations for the fall in Compaq’s share price

do you find most reasonable? Explain.

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6A-2. In the MD&A section of its 2000 Annual Report, Royal Bank of Canada reports “economic profit.” This consists of cash operating earnings less a capital charge of 13.5%, being the bank’s cost of common equity capital. The amounts for the last two years are as follows: 2000

1999

$2,140

$1,600

and one-time items

168

Cash operating earnings

2,227

1,768

Capital charge

(1,460)

(1,386)

$767

$382

Net income after preferred share dividends ($ millions) Add amortization of goodwill, other intangibles,

Economic income Required a.

Relate the concept of economic income here to the clean surplus

valuation procedure in Example 6.2. Does Royal Bank have unrecorded goodwill? (No calculations needed.) b.

Royal Bank also breaks down results for its major business segments. For

example, the personal and commercial financial services segment contributed $469 million of the $767 total economic income for 2000. If you were the manager of a Royal Bank segment, would your propensity to incur large capital expenditures be affected by your knowledge that economic income was a factor in evaluating your performance? Explain why or why not. c.

What new information, if any, is conveyed to the market by Royal Bank’s

disclosure of cash operating earnings and economic income? Why does Royal Bank make these disclosures? 6A-3 Reproduced below is the Economic Value Added (EVA) disclosure from the MD&A section of the 1996 annual report of Domtar, Inc. Some of the uses of EVA are outlined in Domtar’s discussion in the disclosure. Of interest here is the 227 .

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close relationship between the EVA measurement formula and the clean surplusbased valuation procedure outlined in Example 6.2. Note that the EVA for a given year is equivalent to abnormal earnings (oxta) for that year in our example. Recall that goodwill is calculated as the present value of expected future abnormal earnings. It is not clear whether Domtar continues to use EVA, since there is no mention of it in its 2006 annual report. Since 1996 was the last year it gave details of its EVA calculation, we will continue with its 1996 disclosure, as follows: Economic Value Added (EVA) At the end of 1995, the Corporation adopted a new management system known as Economic Value Added, or EVA®, to ensure that the decision-making process at Domtar is aligned with the objective of increasing shareholder value. In 1996, this concept was implemented throughout the Corporation and is being used for measuring performance, evaluating investment decisions, improving communication and for incentive compensation. EVA® training courses were developed and are being provided to a large number of employees in on-going efforts to develop a value creation culture at Domtar. The EVA® measurement formula is as follows: EVA® = NOPAT1 – Capital Charge2 1

Net operating profit after tax

Capital employed × Cost of capital for the Corporation

This simple formula highlights the notion that in order to create value for Domtar shareholders, every business unit must generate returns at least equal to its cost of capital, including both debt and shareholders’ equity.

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Following a record year in 1995 when $316 million of EVA® was created, EVA® for Domtar in 1996 was $120 million negative, due to the decline in selling prices. EVA® = NOPAT – Capital Charge 1995

316

539

223

1996

(120) =

208

Domtar remains committed to creating long-term shareholder value and will intensify its efforts in 1997, especially in areas under its control, such as productivity, costs, customer service, and capital management. Domtar will also benefit from an overall lower cost of capital going forward as a result of its debt management program completed in 1996. Source: Economic Value Added disclosure from Domtar, Inc.’s annual report (1996). Reproduced with permission. Required a.

Evaluate the usefulness of this approach to communicating information to

investors. Consider both relevance and reliability issues. b.

If you were the top manager of a company using EVA, would its use

encourage or discourage you from initiating major, capital intensive expansion projects? Explain why or why not. c.

You are an investor in a fast-growing, high-tech company that reports

EVA. The assets of the company are primarily intangible (patents, skilled workforce) and are unrecorded on the company’s books, hence not included in the EVA capital charge. How would the unrecorded, intangible nature of the assets of such a company affect your interpretation of its EVA? Explain. d.

Note that reporting of EVA is voluntary. Domtar reports this information for

1996 even though its EVA is negative. Does Domtar’s willingness to report this 229 .

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information add credibility to its claim that it “will intensify its efforts in 1997”? Explain. Suggested Solutions to Additional Problems 6A-1. a.

According to single person decision theory and efficient securities market

theory, the share price fell for one or more of the following reasons: •

Earnings came in below expectations of $.95 per share. This would cause investors to revise downwards their expectations of future earnings performance.

•

Concerns about new products and the forecast of “flat” earnings would add to investors concerns about future earnings. Both of these effects would trigger sell decisions, driving down the share price.

•

Beta may be non-stationary. Investors may have increased their perceptions of Compaq’s beta risk. This would increase the expected return demanded by the market (see Equation 4.3), leading to a drop in the current share price (see Equation 4.2).

The provision has a less persistent effect on earnings than a cash loss, since

accruals reverse. If so, the efficient market should react less negatively to the provision than to a realized cash loss. Sloan’s finding, however, was that the market did not make this distinction. Thus, the strong negative market reaction to Compaq’s earnings could be explained as an anomaly–the market reacted more strongly than it should have to the $20.5 million loss provision. c.

According to prospect theory, investors overweight low probabilities and

underweight high ones. Assuming that the foreign currency losses and the failure to achieve expected earnings are rare events for Compaq, investors may overweight the low probability that they will recur and underweight the relatively high probability that operations will revert to normal levels.

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Furthermore, the lower-than-expected earnings creates a loss in value for investors. Under prospect theory, investors exhibit loss aversion—they react strongly to small losses (see Figure 6.2). Note: Loss aversion implies that investors will tend to hold on to “loser” stocks, however. If so, this would reduce, not increase, the downward pressure on Compaq’s share price. All of these effects could explain the strong negative reaction. d.

The chosen explanation is clearly a matter of judgement and preference. Any

of the explanations can be accepted as most reasonable providing that reasonable justification is given. Points to consider include: •

The efficiency explanation has considerable theory (i.e., single-person decision theory and the CAPM) behind it. Even the very volatile market response is consistent with the theory if we recognize that Compaq’s beta may not be stationary. Then, rational investors may have different estimates of beta, causing them to react differently to the same information. This introduces additional volatility into share prices.

•

Prospect theory also has a theory behind it. It is based on a behavioural view of human nature, in particular the concept of narrow framing, rather than a strictly economic view. This explanation would be favoured by those who believe that the securities market is driven by behavioural factors as well as economic ones, and is reinforced by the feeling of at least one analyst who stated that the market “overreacted.”

•

Sloan’s findings are consistent with both a behavioural explanation and a rational investor explanation. Barriers to arbitrage, specifically transactions costs and idiosyncratic risk, prevent the anomaly from being quickly arbitraged away, although transactions costs are not a very satisfactory explanation without knowledge of what these transactions costs should be.

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Fama (Section 6.2.6) argues that alternative models to efficient securities markets have not yet explained the “big picture.” In effect, his argument is that the weight of empirical evidence still favours the rational economic view of securities price formation.

6A-2. a.

Royal Bank’s concept of economic income is related to the clean surplus

valuation procedure through the concept of goodwill. Economic income shows the current instalment of the ability of the bank to earn a return greater than its cost of capital. Ability to earn an excess return on capital is the essence of goodwill. The clean surplus valuation procedure capitalizes the expected future stream of excess earnings. The Royal Bank’s procedure differs from the clean surplus procedure, however, since it applies to the current year, not to future years. Current year’s performance is already incorporated into the balance sheet under clean surplus. It seems, however, that Royal Bank does have unrecorded goodwill. If it did not, economic income (i.e., abnormal earnings) for the current year would be zero. This is because if all unrecorded intangibles were recorded on the balance sheet at their fair value, the bank would earn only its cost of capital on total net assets. b.

Yes. I would thoroughly evaluate large capital expenditures. These would

be accepted only if there was a high probability of a return greater than the cost of capital. I would tend to avoid risky projects because if the expected high returns did not materialize my economic income would be negative. This would adversely affect my performance evaluation. c. Little, if any, new information is conveyed to the market by economic income. The market can estimate Royal Bank’s cost of capital and can make the economic income calculation for itself. There would be new information conveyed if Royal Bank’s cost of capital of 13.5% differed from the market’s evaluation, and reflected inside information of management. 232 .

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Adding back goodwill amortization and other intangible and one-time items to determine cash operating earnings could assist the market in evaluating Royal Bank’s earnings persistence if these items were not fully disclosed in the financial statements. The bank may make the cash income and economic income disclosures because it feels that these earnings concepts better portray its results of operations. Alternatively, the bank may feel that amortization of (recorded) goodwill and other intangibles does not reflect its financial performance. Consequently, it adds these back to determine what it calls cash operating earnings. However, it may feel defensive about its high cash operating earnings, which seem high relative to its cost of capital, and may want to try to convince investors, and the public, that profitability should be measured after a capital charge. Since this produces a lower number, the bank may feel that concern about excessive bank profits will be reduced. 6A-3 a.

The information is potentially useful to investors since it emphasizes that

earnings do not augment firm value unless they exceed expected earnings, that is, earnings greater than the cost of capital used to earn them. This is consistent with the clean surplus Equation 6.1, where goodwill is the present value of future abnormal earnings. The EVA information may help investors to evaluate the goodwill component of firm value. A counter argument is that investors already have sufficient information (including cost of capital, which can be estimated from the CAPM, or by inverting the clean surplus formula–see last paragraph of Section 6.10.4) to calculate EVA for themselves. Given securities market efficiency, the information in the EVA would be incorporated into share price as soon as the current year’s earnings and financial statements were released. Thus, while it may serve as a convenience for investors who do not wish to make the calculations for themselves, the EVA adds little to the information possessed by the market. Since the firm may have a better estimate than the market of its cost of capital, a

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possible exception is that the market may obtain a better cost of capital estimate, assuming the firm discloses this rate in its capital charge calculations. The relevance of EVA is high or low depending on which of the foregoing arguments is accepted. With respect to reliability, the EVA information is similar in reliability to the financial statement information on which it is based. If capital employed and net operating profit are based on historical cost accounting, reliability would be relatively high. To the extent that they are based on current values, reliability may be lower, depending on the extent to which well-working market prices are not available for fair value calculations and the extent of error and bias in value-inuse calculations.. b.

EVA may discourage the top manager from initiating major capital

expenditures since these would carry with them an automatic capital charge. Even if the expected value of a project exceeds the capital charge, the manager may be discouraged if the project is risky. The riskier the project, the higher the probability that project earnings may dip below cost of capital at some point, resulting in a negative EVA. Of course, discouraging capital investment is not necessarily bad, since EVA puts managers on notice that new investment should earn at least its cost of capital. Thus, the discouragement would be primarily with respect to marginal and/or risky projects. c.

Given that the intangible assets are not included in the capital base, the

effect would be to raise the reported EVA. As a result, the greater the proportion of unrecorded intangibles in firm value, the higher the EVA would have to be before it is interpreted as satisfactory. This is because unrecorded intangibles show up in reported earnings over time as their value is realized, not in the capital base. In clean surplus terms, they are part of abnormal earnings rather than part of the balance sheet.

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Another interpretative aspect is that to the extent intangibles are not included in the capital base, the firm may overinvest in expenditures that create unrecorded intangibles, such as R&D. Notes: For further discussion of these and other aspects of EVA, see also, “Valuing Companies: a star to sail by,” The Economist, August 2, 1997, pp. 53-55. Since amortization of purchased goodwill was removed from GAAP in 2001 in Canada and the U.S. and 2004 internationally (see Section 7.11.2), purchased goodwill is fully included in the capital base for EVA. Prior to 2001/2004, such goodwill was included in the capital base only to the extent it was not amortized. One can then raise the question of whether or not the elimination of amortization imposes greater discipline on managers of parent companies not to overpay for acquisitions. Instructors who wish to consider the accounting, or lack of accounting, for unrecorded intangible assets and its effects on reported earnings and EVA in greater depth may find the following suggestion of interest: Numerous authors have pointed out that the value of many firms, such as the high tech firms mentioned in part c, comes primarily from intangible rather than tangible assets. This raises questions about the adequacy of historical cost-based accounting for such firms. Intangible assets are seldom recorded, unless they have been purchased (see Section 7.11.2), despite the lack of relevance that ensues. The reason for not recording self-developed intangibles, presumably, is due to problems of reliability. In effect, the accountant throws up his/her hands and requires immediate writeoff of expenditures such as advertising, R&D, and employee training. As mentioned, intangibles do show up, but only as realized over time in the form of higher earnings and EVA. 235 .

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In this regard, The Economist, (June 6, 1998, p.64) contains an outline of a proposal by Edvinson and Malone (Leif Edvinson and Michael Malone, “Intellectual Capital,” Harper Business, 1997). To arrive at a value for total intangible assets (i.e., intellectual capital), these authors suggest that the fair value of net physical assets be deducted from the market value of the firm. Intellectual capital is then prorated into various components, such as human capital, patents and copyrights, etc. These values can then serve as the basis for a “constructive debate” as to whether the capital market has over or undervalued their real worth. However, this suggestion is unlikely to add much to what the market already knows about the value of intangible assets. The difference between the firm’s market value and the fair value of its net physical assets is the market’s assessment of the value of its goodwill. The role of financial reporting is to add to what the market knows, not simply to reflect what it knows. There thus seems little scope for a “constructive debate.” d.

Yes, it adds credibility. Domtar’s management would hardly be expected

to report voluntarily the rather bleak EVA this year if they did not expect to do better next year. In effect, reporting EVA this year puts their expectations for next year on the line. The market would realize that they must have plans to turn operations around. Note: Domtar did not do better in 1997, and its 1997 annual report contained only brief reference to EVA.

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CHAPTER 7 MEASUREMENT APPLICATIONS

7.1

Overview

7.2

Current Value Accounting 7.2.1 Two Versions of Current Value Accounting 7.2.2 Current Value Accounting and the Income Statement 7.2.3 Summary

7.3

Longstanding Measurement Examples 7.3.1 Accounts Receivable and Payable 7.3.2 Cash Flows Fixed by Contract 7.3.3 The Lower-of-Cost-or-Market Rule 7.3.4 Revaluation Option for Property, Plant, and Equipment 7.3.5 Impairment Test for Property, Plant, and Equipment 7.3.6 Summary

7.4

Financial Instruments Defined

7.5

Primary Financial Instruments 7.5.1 Standard Setters Back Down Somewhat on Fair Value Accounting 7.5.2 Longer-Run Changes to Fair Value Accounting 7.5.3 The Fair Value Option 7.5.4 Loan Loss Provisioning* 7.5.5 Summary and Conclusion

7.6

Fair Value versus Historical Cost*

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7.7

Liquidity Risk and Financial Reporting Quality*

7.8

Derecognition and Consolidation

7.9

Derivative Instruments 7.9.1 Characteristics of Derivatives 7.9.2 Hedge Accounting

7.10

Conclusions on Accounting for Financial Instruments

7.11

Accounting for Intangibles 7.11.1 Introduction 7.11.2 Accounting for Purchased Goodwill 7.11.3 Self-Developed Goodwill 7.11.4 The Clean Surplus Model Revisited 7.11.5 Summary

7.12

Reporting on Risk 7.12.1 Beta Risk 7.12.2 Why Do Firms Manage Firm-Specific Risk? 7.12.3 Stock Market Reaction to Other Risks 7.12.4 A Measurement Approach to Risk Reporting 7.12.5 Summary

7.13

Conclusions on Measurement Applications

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES

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To Introduce the Major Financial Instrument Accounting Standards

My purpose in covering the accounting for financial instruments is twofold. First, consistent with the main purpose of this chapter, I use these standards as a way to explore the extent to which standard setters are adopting a measurement perspective for financial instruments. Second, I hope to give senior undergraduate accounting students exposure, at a fairly general level, to the contents and reasoning of the main financial instruments standards’ they will be facing when they enter practice or industry. Nevertheless, instructors may wish to pick and choose the topics they cover. There are two optional sections. Section 7.5.4 deals with loan loss provisioning, where it appears that a new standard will be some time coming. Section 7.6 outlines some analytical work on fair value versus historical cost accounting. While I feel that some of the implications of this analytical work are worth noting, they may be of only peripheral interest to some students and instructors. Other sections that could be dropped with little loss of continuity include Section 7.7 re market liquidity, although the recent market meltdowns have heightened interest in liquidity, at least in the lack of it. Section 7.5.1 re the stopgap changes in standards resulting from the severe criticisms of fair value accounting during the recent market meltdowns will lose interest over time. Section 7.5.3, dealing with mismatch and the fair value option may be perceived as too esoteric by some, although I feel that students who are planning a career in accounting should be exposed to these concepts, particularly since they relate to reporting on risk. Section 7.8 dealing with new standards for derecognition and consolidation is subject to the same comment. 2.

The Distinction between Fair Value and Value-In-Use

This distinction is important since recent IASB accounting standards, such as IFRS 9, exhibit some backing off from fair value towards amortized cost, a version of value-inuse but using the discount rate established at acquisition. 239 .

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Points to bring out include: •

The fair value hierarchy, including trade-offs between relevance and reliability.

•

The concept of amortized cost.

•

The opportunity cost interpretation of fair value. This moves the income statement in a stewardship direction since we can interpret measuring assets at fair value as charging management with the opening opportunity cost of the assets entrusted to it. The income statement can then be interpreted as a report on the ability of management to earn more than cost of capital on assets used in the business. If not, the firm would be better off to sell the assets (or dismiss the manager).

To Review Long-Standing Examples of Current Cost Accounting

Section 7.3 is a mainly descriptive section designed to review common examples of measurement. The concept of impairment tests is important since it pervades fair value accounting, particularly for financial instruments. This text treats impairment tests, including lower-of-cost-or-market, as partial applications of current cost accounting. This is appropriate, I feel, when we are talking about impairment tests from the standpoint of investors. Under contract theory, discussed in Chapter 8, impairment has a somewhat different rationale. 4.

To Introduce the Accounting for Financial Assets and Liabilities

This is a complex topic, and one which is undergoing considerable change. The IASB is currently in the process of replacing IAS 39, with a view to simplifying the accounting for financial instruments. IFRS 9, Financial Instruments is the first result of this process, although it is not effective until January 1, 2015. Instructors should be alert for possible changes in this standard by that date, particularly with respect to the business model concept, since the accounting for financial instruments is not yet converged with the FASB.

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I feel it is important not to get bogged down in this topic. Suggestions for points that can be usefully discussed are: •

The concept of business model. This is a clever way to operationalize value-inuse accounting. It, hopefully, controls the possibility that management may change its intended use of an asset so as to influence the accounting valuation.

•

The concept of mismatch, leading to the IASB version of the fair value option. Theory in Practice 7.2 re Morgan Stanley could be used as a basis for discussion, although it relates to the U.S. version, which does not restrict to mismatch. Theory in Practice 7.4 re Blackstone illustrates another U.S. implementation of the fair value option, in a derivatives context.

•

The new standards on derecognition and consolidation can be used as a basis for discussion of the standard setters response to some of the accounting problems with off-balance sheet entities leading up to the 2007-2008 market meltdowns. An important question for discussion is whether these new standards will prevent these accounting problems from recurring. Theory in Practice 7.3 re Repo 105s illustrates some of the complexities surrounding derecognition and how it has been abused.

To Introduce Accounting for Derivative Financial Instruments

Students should be aware of the need for firms to manage risks. Also, I have noted that students often bring little or no prior understanding of derivatives. Points that could be emphasized include: •

The concept of a natural hedge.

•

What is a derivative financial instrument?

•

Managing risks versus speculation as reasons for dealing in derivatives. Perhaps the best way to approach this topic is to discuss one of the “horror stories” resulting from derivatives speculation—see Note 18 of this chapter.

•

The distinction between fair value hedges and cash flow hedges.

• Basic accounting for both types of hedges. 241 .

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To Evaluate a Measurement Perspective on Intangibles

In Example 7.1, the text gives a simple example of purchase accounting for subsidiary acquisition. This leads to purchased goodwill. The text briefly discusses pro-forma net income, which in large measure was managements’ response to the amortization of purchased goodwill. Theory in Practice 7.5 illustrates extreme cases of pro-forma reporting. Problems of reliability are particularly serious in the accounting for self-developed goodwill. Yet, according to Lev & Zarowin (1999), this is the reason for the low and decreasing R2 of net income in explaining share return variability. Their suggestion for capitalizing R&D costs once a research project passes a critical “hurdle” seems a reasonable compromise between relevance and reliability, and is an extension of R&D accounting in IASB standards, where development costs may be capitalized. The Lev and Zarowin paper is quite readable, and could be assigned as reading by instructors who wish to spend more time on accounting for R&D and goodwill from a measurement perspective. If a clean surplus valuation project, as suggested in Chapter 6 (Chapter 6, Problem 12), has been assigned, the question of using the clean surplus approach to measuring self-developed goodwill (or badwill) can also be discussed. 7.

Reporting on Risk

Reporting on risk is an increasingly important component of financial reporting. For example, the standards on derecognition, consolidation, and disclosure (Section 7.8) require risk assessments and disclosure. Reporting on risk immediately raises the question of whether it is consistent with the principle of portfolio diversification and CAPM, which implies that a stock’s beta is the only relevant risk measure. However, the text suggests several reasons why firmspecific risk is relevant to investors. The most important reason, at least from a theoretical perspective, is estimation risk. Investors are concerned about estimation risk since it results from concerns about insider exploitation about their information 242 .

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advantage (i.e., adverse selection). To the extent the firm employs astute risk management strategies, and investors know what these strategies are, estimation risk is reduced because there is less risk that insiders will be able to exploit advance knowledge of bad, or good, state realizations. For whatever reason, empirical evidence outlined in Section 7.5.3 suggests that investors are sensitive to firm-specific risk information, at least for financial institutions. Also, from an ex post perspective, material realizations of downside risk, such as from unfortunate dealings in derivatives, seem to draw auditors into the lawsuits that follow. It seems doubtful that an argument based on diversification (i.e., that diversified investors should offset their losses from the shares in question in the lawsuit with favourable realizations of their other investments), is a convincing defence in a court of law. A question for discussion is whether narrative risk disclosures in MD&A, as illustrated in Section 3.6.3 for Canadian Tire Corp., can provide adequate risk information or whether they should be supplemented with quantitative risk measures such as those described in Section 7.12.4 SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

Strictly speaking the answer is yes, since post-revenue-realization assets such as accounts receivable are valued at the net amount expected to be received. This amount approximates present value if we accept that the time to collection is sufficiently short that discounting is not needed. Present value (i.e., value-in-use) is a version of current value, consistent with a measurement approach, not a cost approach. Complete historical cost accounting for accounts receivable would require them to be valued at cost of the inventory or services sold until cash is received. A no answer can also be argued if we accept that the historical cost basis of accounting only holds up to the point in the firm’s operating cycle at which revenue is regarded as earned, usually the point of sale. Financial assets

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generated subsequent to this point can be valued at current value without violating the historical cost basis of accounting. 2.

Note: The purpose of this question is to discuss why deferred revenue does not exist under full current cost accounting. a.

Under historical cost accounting, the income statement is the primary

financial statement. Net income for a period represents the difference between revenue recognized during the period and the historical costs of earning that revenue. When revenue is received in advance, it is deferred on the balance sheet to future periods when it will be matched with the costs of earning that revenue. In effect, this deferred revenue is viewed as an accrual to defer revenue that is not yet earned. Revenue each period can be determined by amortizing the deferred revenue on some systematic basis such as straight line. Under the measurement approach, the balance sheet assumes greater importance. The role of the income statement is to explain changes in the current values of assets and liabilities during the period. Revenue received in advance is viewed as a liability to be measured at current value. One way to measure this value is to determine the amount the firm would be willing to pay to be relieved of this service obligation. Revenue for the period is recognized as the decline in this value during the period. b. The firm could calculate the discounted present value of the costs expected to meet its contractual liability for updates and virus protection. This is the amount the company would be rationally willing to pay to be relieved of this obligation. However, if there is a market for the required services, and the market value of the services is less than the company’s cost estimate, the obligation would be valued at the lower amount. This is now the amount that the company would rationally pay to be relieved of the obligation. Either way, the liability would be remeasured at each period end over the three years, to show the expected cash outflows remaining. 244 .

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The approach suggested in b is more relevant than the matching

approach since it measures expected future cash flows. Under historical cost accounting, the balance sheet measure of the obligation does not measure future cash flows but rather the portion of the deferred revenue remaining to be allocated to future periods. The approach suggested in b is less reliable that the matching approach. Allocation over three years is a straightforward calculation, whereas an estimate of discounted future expected cash flows is subject to estimation error and possible bias. 3.

Perhaps the main reason is cost. Since hedging transactions are costly,

the firm may feel that the optimal cost-benefit trade-off is not at zero risk. Also, the firm may be at least partially protected by natural hedging. Another cost-related reason is that investors can diversify firm-specific risk themselves. Investors may feel they can manage firm-specific risk themselves more cheaply through diversification than the firm can through costly hedging and natural hedging. As a result, they would object if management engaged in excessive risk-avoidance through hedging transactions. Perfect hedges are not always available. It may be difficult or impossible to find a hedging instrument that has a perfect negative correlation with the value of the item to be hedged. As a result, firms must bear some basis risk. The firm may not be planning any costly internally financed capital projects, so that it does not anticipate a need to ensure a large amount of cash will be available. Consequently, the firm may feel less need to hedge its future cash flows than it would otherwise. Investors and, on their behalf, the firm’s Board of Directors, may be concerned that excessive hedging may slip into speculation, which places more risk, rather

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than less, on the firm. As a result, the Board may limit, or at least closely monitor, the extent of the firm’s hedging. 4.

High operating leverage in a firm’s cost structure means a high sensitivity

of earnings to changes in revenues, as illustrated in the case of Yahoo Inc. Since stock prices are sensitive to earnings, high operating leverage means high stock price variability when revenue changes. b.

If firms’ betas are non-stationary, investors will want to know when and by

how much they change. This is difficult to know, since it takes time to gather enough data to re-estimate beta using regression techniques based on the market model. Even a financial statement-based approach to estimating beta, discussed in section 7.12.1, may have to wait until the next set of financial statements is available. Consequently, investors face estimation risk, and will have differing estimates of the value of a firm’s beta. Since beta is an input into investor’s decisions, non-stationarity introduces an additional source of variability into these decisions, even if all other information is the same. This variability increases share price volatility. Note: It can be argued that if beta risk can be diversified in a portfolio of securities, investors will care less about beta estimation risk. If so, stock price variability arising from non-stationarity of beta will be reduced, or even eliminated. c.

Momentum is a product of self-attribution bias, whereby good investment outcomes reinforce an investor’s confidence, leading to the purchase of more shares. This drives share price higher than it would be if all investors were rational. A stock market bubble is an extreme case of momentum trading. Over time, however, share price reverts towards its efficient market level, as it becomes apparent that prices are too high. In the case of a bubble, the reversion can be very swift. The combination of too-high stock prices driven by momentum and subsequent reversion produces high stock price volatility.

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No, they are not mutually exclusive. There is no reason why non-stationarity of beta, momentum and bubbles cannot exist in the presence of high operating leverage. Furthermore, some investors are rational, and their trading behaviour may be affected by high operating leverage and non-stationarity, while other investors may be subject to self-attribution bias. Then, both types of investors contribute to volatility. In effect, the three sources of volatility complement each other. Note: An alternative argument can be made that high operating leverage and non-stationarity sources of volatility are consistent with rational investor behaviour. With respect to non-stationarity, see the discussion of non-stationarity of beta in Section 6.2.3, and the discussion of Brav and Heaton (2002) in Section 6.5.1 )optional section0. Biased self-attribution is not consistent with rationality. If the effects of operating leverage and non-stationarity on volatility are driven by rational investors whereas the effects of momentum on volatility are driven by behavioural factors, it can be argued that they are mutually exclusive.

The three policies are increasing in relevance. IAS 39 was lowest in relevance. Under IAS 39, loans were valued at their discounted expected future receipts before any provision for credit losses. Credit losses were recognized as loans become impaired. Since the essence of relevance is to predict future cash flows, a delay in recognizing impairment until it has taken place reduces relevance relative to policies that attempt to anticipate future credit losses even if the loan is not currently impaired. The Basel Committee’s suggested policy is the most relevant of all, since it predicts cash flows over the business cycle, rather than over the term of the loan as in the 2009 IASB proposal. In effect, the Basel Committee’s proposal predicts cash flows over a longer period than the IASB proposal. b.

The three policies are decreasing in reliability. As the period over which

credit losses are predicted lengthens, the potential for errors of estimation and bias in projecting future loan losses and discount rates increases. 247 .

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Fair value accounting for loans would require valuing them at their market

value (Level 1) or at an estimate of market value (Levels 2 and 3). Under Level 3, market value could perhaps be approximated by valuing loans at present values discounted at a current interest rate rather than at the effective rate established at loan acquisition. If Level 1 valuation (and to a lesser extent Level 2) are feasible, valuing loans at market value would be most consistent with the measurement perspective (i.e., at fair value) since market value would include the market’s expectations of future credit losses, and should be reasonably reliable. Level 3 valuations would be less reliable since expected future receipts and discount rates are subject to error and possible bias. Only if the increase in relevance of Level 3 valuations exceeded the decrease in reliability should fair value accounting be applied. A reasonable conclusion is that fair value should not be adopted since most loans are unlikely to have a market value, and the resulting need to apply Level 3 introduces considerable unreliability. Note: The most likely reason for loan loss provisioning, particularly dynamic provisioning, rather than fair value accounting, is political. Since interest rates and market values, if they exist, are volatile, fair value accounting for loans increases earnings volatility. This is particularly so during a severe downturn in the business cycle, that is, a recession, when liquidity pricing may result, leading to huge writedowns. This results in severe pressure from management, who object to fair valuation of loans when their intent is to hold them to maturity. Also, pressure from governments results, due to the effects of huge writedowns on economic activity. 6.

One reason is as a form of credit enhancement. By retaining an interest,

hence bearing some risk, the company demonstrated its commitment to the quality of its mortgage lending procedures. Another reason is that the company would earn interest income (i.e., accretion of discount) on the retained interests, thereby bolstering its income statement. 248 .

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Third, since retained interests were valued at fair value, and since no secondary market existed for these retained interests, they were valued on a discounted present value basis. The resulting need for estimates gave New Century considerable latitude in the discounted present value calculations. The company may have used this latitude to bias current value estimates, thereby increasing or smoothing reported net income. b.

Again, this was a form of credit enhancement. New Century would receive

a higher price for mortgages transferred. The company probably believed that house prices would continue to rise, so that mortgage delinquencies would be rare. c.

Under IFRS 9, derecognition is allowed when the firm transfers

substantially all of the risks and rewards of ownership of the mortgages sold. The question then is, does a one year commitment to buy back troubled mortgages violate transferring all the risks? Undoubtedly, some risk remains for New Century. However, due to buoyant expectations about the future of the housing market at the time, New Century could argue that the risk of buying back was low and, if a mortgage was bought back, the loan could be sold or refinanced with little loss. Thus, treating the mortgages transferred as sales and providing for expected credit losses on mortgages bought back would seem to have been feasible under IFRS 9. However, IFRS 7 requires disclosure of assets that have been derecognized but in which the firm has a continuing involvement. IFRS 12 requires disclosure of interests in and risks arising from joint arrangements with others. It thus seems that the market would have been aware of New Century’s one-year buyback commitments and its revenue recognition policies. Whether this information would have led to an increase in investor risk assessments, reduction of leverage, and higher cost of capital sufficient to reduce the extent of New Century’s activities to the point that it would have avoided bankruptcy is difficult to say.

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Also, much of New Century’s early revenue recognition from retained interests and servicing rights would have to be reversed as mortgages collapsed. This would have led to large reported losses regardless of whether or not it derecognized its securitized mortgages, further increasing the likelihood of share price collapse and bankruptcy. Given the buoyant expectations at the time regarding the future of the housing market, a reasonable conclusion is that the new standards would not have prevented New Century’s bankruptcy.

Reasons to agree with Mr. Fink: •

If markets work well, current asset price is the best estimate of prices in all future periods. This “more accurate appraisal” should help investors to predict future cash flows. That is, fair values are high in relevance.

•

To the extent that fair value accounting increases transparency (i.e., higher earnings quality), investors benefit through lower estimation risk. Mr. Fink may feel that fair values are more transparent in the sense that fair values may increase the ability of investors to predict future firm performance relative to other bases of valuation such as historical cost. Also, if markets work well, fair values are reliable, particularly in the sense of lowering estimation risk due to less ability of the manager to bias the valuation.

•

A dictionary definition of granularity is “composed of small compact particles.” This seems to imply that fair value accounting increases the ability of investors to see inside the business. Mister Fink may feel that by marking to market individual assets, investors can see which assets have increased in value and which have decreased. This may help them to evaluate risk and trends in firm performance.

•

Since market values tend to be volatile, Mr Fink is correct in expecting that this will cause managers and investors to be concerned about quarterly results. This diverts managers’ attentions from longer term activities, which 250 .

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may be of greater long term benefit to investors. Also, to lower short-term volatility, managers may engage in costly hedging, or may engage in earnings management, for example, by manipulating loan loss provisions, to smooth out earnings.

Reason to disagree with Mr. Fink: •

Mr. Fink ignores reliability when he suggests that fair value accounting is good for investors. To the extent that fair values are not derived from markets that work well, they are subject to possible error and manager bias (e.g., Level 3 and, to a lesser extent, Level 2). If reliability is sufficiently low, this would wipe out the benefits to investors of greater relevance.

•

Fair value accounting, by, in effect, charging managers with the opportunity cost of firm assets and liabilities, will encourage stewardship, since if the manager cannot earn at least cost of capital on opportunity cost, the firm should be reorganized or sold. Thus fair value accounting can motivate improved manager performance, to investors’ longer term benefit.

According to IFRS 9, Barclays must transfer substantially all the risks and

rewards of ownership of the securities in question in order to derecognize. It seems from the information available that the rewards of the securities have been transferred, since increases in fair value accrue to C12. However, it is not clear that the risks have been transferred, since almost all of the selling price is financed by a loan from Barclays Capital. Should the transferred securities decline in value, it is unclear how the loan would be repaid by C12. A reasonable conclusion is that this deal would not qualify as a sale under IFRS 9. Since the IFRS derecognition standard has been converged with U.S. GAAP, this conclusion would also be consistent with FASB standards. Note: IFRS 9 is not scheduled to come into effect until 2015. 251 .

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Note: Barclays did not derecognize the transferred securities for regulatory purposes. Thus, they are included in the asset base upon which Barclays’ required regulatory capital is calculated. Perhaps Barclays has adopted this policy deliberately, so as to reduce any concerns the regulator may have about the deal. Nevertheless, not derecognizing for regulatory purposes also questions derecognition for financial reporting. b.

Under IFRS 10, consolidation is required when one entity controls

another. Control exists when one firm (Barclays) has power to direct the activities and shares in the risks of another (C12). Since Barclays Capital pays an annual fee of $40 million to C12 for management of the transferred securities, it seems that control has been transferred to C12. However, as pointed out in a., if the cash flow from the transferred securities becomes insufficient to meet loan repayments, Barclays would likely have to absorb the loss, in which case it could be deemed to share in losses (i.e., bear risk) of C12. A reasonable conclusion is that Barclays would be required to consolidate C12 under IFRS 10. Note: IFRS 12 requires that significant judgements made in the decision about whether control exists would have to be disclosed. IFRS 7 requires disclosure of assets that have been derecognized but in which the firm has a continuing interest. The ownership of C!2 (former Barclays employees) and the possibility of losses on its loan to C12 suggest that disclosure of the transferred securities must be disclosed. Since the IFRS consolidation standard has been converged with U.S. GAAP, this conclusion would also be consistent with FASB standards. c.

The return on the market (FTSE 100) on September 16 was 82/(5124.10 –

82) = .0163. According to the market model (Section 4.5), with αj = Rf(1 – βj) = 0 and RMt = .0163, we expect Barclays’ share return on September 16 to be Rjt = 0 + 2.1568 x .0163 = .0352 Abnormal return is actual minus expected return: 252 .

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Εjt = .0290 - .0352. = -.0062 Since abnormal return is negative, it seems that the market disapproved of the deal. 9.

Arguments against fair valuing long-term debt: •

Market value of debt falls following a credit downgrade. It may seem strange to many persons that the firm record a gain following a credit downgrade.

•

The reduction or increase in fair value of debt, from changes in market interest rates or credit downgrade, or both, creates a wealth transfer from debtholders to shareholders. Under the equity view of financial reporting, a wealth transfer is not a gain or loss to the entity. Thus, no gain or loss should be recognized.

• Many firm assets, such as self-developed goodwill, patents, R&D, are not valued on the balance sheet. Downgrades or increases in the credit rating of debt is frequently due to changes in the value of these assets. Yet, such changes are not recognized in current earnings, while if debt is fair valued, changes in fair value are included. This creates a mismatch situation that increases the volatility of reported earnings. Arguments in favour of fair valuing long-term debt: • To the extent firm assets are fair valued on the balance sheet, and changes in fair value contribute to changes in the firm’s credit rating, failure to fair value debt creates a mismatch. If so, firms should be required to fair value their debt, so as to reduce mismatch. • If the proprietorship view of financial reporting is accepted, changes in the fair value of debt represent a gain to shareholders, which should be reflected in earnings. • To the extent that the balance sheet is the primary financial statement, assets and liabilities should be fair valued, subject to reasonable reliability. 253 .

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Inability to fair value certain assets, such as intangibles, should not be used as a reason not to fair value liabilities. 10.

No. If the inventory has fallen in value, the value of the forward contract has risen. Since the forward contract is an effective hedge, any writedown of inventory under the lower-of-cost-or-market rule will be offset by a gain from valuing the hedging instrument at fair value. Note: To the extent the contract is not fully effective, there could be a small reduction in net income. Note: Since firms cannot overhedge, it is unlikely that a net gain would be recorded.

11.

The increase in Ballard’s share price implies a low R2 and ERC. There

was a positive firm-specific (i.e., abnormal) return on Ballard’s shares in response to the increase in its reported loss (i.e., a negative change in earnings). This implies a low ability of net income to explain the market response (i.e., low R2), and a negative ERC. This implication is consistent with Lev and Zarowin (LZ), who argue that the primary reason for low R2 and ERC is failure to record the fair value of self-developed goodwill, such as that resulting from R&D. b.

LZ suggest capitalization of accumulated R&D costs once they pass a

hurdle that suggests a successful research project. The higher the hurdle, the higher the reliability of the capitalized R&D. Adoption of this suggestion would increase R2 and ERC. The mismatch between the timing of the costs and benefits of the R&D would be reduced. It is this mismatch, where the costs are charged to expense prior to the benefits that result that produces the situation of Ballard Power. Under the LZ proposal, assuming that the Ballard technology has reached a hurdle point, the market response to 254 .

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the successful R&D program and the GN or BN in reported earnings would take place at the same time, thereby increasing the association between share return and abnormal earnings. Complete reliability of R&D accounting is not necessary for the Lev & Zarowin proposal, due to the concept of a fully revealing signalling equilibrium. To the extent that the market takes the large investment by Ballard in R&D as a signal of the firm’s research potential, share price gets an extra increase over and above the expected future profitability of the capitalized research itself. This encourages Ballard management to overinvest in R&D, leading to future share price decline as the market realizes the overinvestment. Relatively low reliability will reduce this effect, since the initial market overreaction is dampened. c.

Ballard’s doubling of its R&D costs signals that it anticipates future

success from its fuel cell technology. The abnormal return on Ballard’s shares was positive upon receipt of this information. This suggests securities market efficiency, since, despite an increased reported loss, the market has responded favourably to information that suggests increased probability of future R&D payoffs. 12.

There is some justification to this claim, since it removes from GAAP

earnings the lingering negative effects of Manulife’s failure to hedge against the possibility of lower interest rates and stock returns. Presumably, post-meltdown business is charging higher rates to allow for these lower investment returns. Also, increased hedging of interest rates and stock returns reduces the effects of any future reductions in investment returns on earnings. Both of these factors suggest higher net income in future. Also, fair values tend to be volatile. Since many of the company’s investment assets are held longer-term, earnings volatility is of less concern. Thus, earnings before fair value gains and losses should better predict future average earnings.

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As suggested in part a, to the extent that persistent earnings better predict

future earnings performance, the Manulife calculation is useful to investors. However, the answer really depends on how long low interest rates will persist, and how long it takes Manulife to more fully hedge against future changes in investment returns. If low returns persist, and if investment returns are not fully hedged, its persistent earnings calculation will overstate future earnings performance, particularly since hedging is costly. A reasonable conclusion is that while Manulife’s persistent earnings may be of some usefulness to investors, the degree of usefulness is reduced to the extent investment returns remain low and hedging is costly. c.

Manulife’s failure to hedge interest rate and share return risk was a

management decision. Its persistent earnings calculation removes much of the loss in profits that resulted from these lower investment returns. Consequently, adding back losses that result from lower returns lets management “off-the-hook,” and thus does not represent stewardship very well. To the extent that investment assets are held longer-term, management may claim that the volatility introduced by fair valuing these assets each period does not fairly represent its performance. However, this argument should not be pushed too far. The particular assets acquired are a management decision. Fair value accounting tracks the performance and volatility of these assets over time, giving investors information about management’s investment ability. This information should not be hidden from investors. A reasonable conclusion is the GAAP net income better reports on manager stewardship than core earnings. d.

The return on the TSX on November 8, 2012 was (12197.05 -

12,227.85)/12,227.85 = -30.80/12,227.85 = -.0025. According to the market model (Section 4.5), with αj = Rf(1 – βj) = 0 and RMt = -.0025, we expect Manulife’s share return on November 8 to be 256 .

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Rjt = 0 + 1.48 x -.0025 = -.0037 The actual return on Manulife shares on November 8 was -.18/12. = -.0150. Abnormal return is actual minus expected return on Manulife shares: ejt = -.0150 + .0037 = -.0113 Since abnormal return is negative, it seems that the market was not impressed by Manulife’s persistent earnings calculation. 13. a.

Net income calculated this way would add nothing to what the market

already knows. If security markets are efficient, the share prices would already incorporate all that the market knows. If markets are not fully efficient, that is, shares are mispriced, the suggestion would simply perpetuate the mispricing. b.

This suggestion suggests a limit to the extension of fair value accounting.

While fair valuation of individual assets and liabilities may be decision useful, fair valuation of all of them, including self-developed intangibles, would not be decision useful, as per a. The reason is that the fair value of self-developed goodwill captures the ability of management to earn a return in excess of cost of capital on the tangible and intangible net assets used to operate the business. The fair value of self developed goodwill merely records the market’s estimate of this excess earnings ability, and thus adds nothing to what the market already knows. However, value-in-use (i.e., present value) of self-developed goodwill would be decision useful if relevance outweighed problems of reliability, since present value would reveal inside information about management’s expectations of future firm performance. 14.

If the CAPM and theory of rational decision-making are accepted, the risk

information seems largely firm-specific, hence diversifiable. Then, firm-specific risk information would be low in relevance. That is, firm-specific risk information may help to predict future firm cash flows, but this prediction would not be relevant to diversified investors to the extent this source of cash flow risk is diversified away. 257 .

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However, the CAPM ignores estimation risk. Then, relevance is higher, since it reveals concise information about the response of cash flows and earnings to various price risks. Since it is management that has the best information about its operations and cost structures, the sensitivities disclosures would likely reveal inside information, thereby reducing estimation risk. Relevance would also be high for investors who are not well diversified, since firm specific risk information then affects their expected utility from their Husky investment. With respect to reliability, this can be questioned. The effects of price changes on cash flows and earnings are unlikely to be linear (one reason being the presence of fixed costs), except over a narrow range. Yet, no relevant range information is given. Also, the impact of each price change assumes that the other prices are held constant. However, due to cross-relationships, this is unlikely to be the case. Thus, if two or more prices change together, the impact on cash flows and earnings need not be the sum of the given impacts for each price change. Both of these problems reduce the representational faithfulness (i.e., reliability) of the risk information. b.

To the extent Husky has reduced its real risks by hedging, the investor

who wants firm-specific risk information would find sensitivity information net of hedging more useful, since these better reflect the actual level of firm risk. However, there are some problems analyzing sensitivities net of hedging. These include: •

The extent of hedging may vary over time.

•

Hedge effectiveness may vary over time.

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The level of activities subject to price risk, such as foreign sales, may vary over time. Hence the need for hedging may vary. (Changing activity levels would also affect the sensitivities themselves.)

•

The firm may be concerned about giving out information which may benefit competitors. For example, if Husky was to hedge only the risk of oil price decreases, this may reveal that it expects oil prices to fall. Reporting sensitivities before hedging would not reveal information such as this.

Some of these problems would be reduced given that the firm fully discloses its hedging activities as supplementary information. For example, the investor could then interpret net-of-hedging risk information in the light of the firm’s current extent of hedging, hedge effectiveness, and level of price-sensitive activities. A reasonable conclusion is that sensitivity information net of hedging is more decision useful. c.

The Board may be concerned that excessive hedging may turn into

speculation. Controlling management’s extent of hedging would help to control and limit speculative activity. Hedging is not costless. The Board may seek a reasonable trade-off between the benefits and costs of hedging. Managers may want to hedge more than this for personal reasons, such as reporting a smooth earnings sequence over time. The Board may feel that investors can diversify firm-specific risk for themselves, with little need for the company to do it for them. 15.

Requirements for designation: •

Management must document the nature of the risk being hedged and identify the hedged item. Documentation should be consistent 259 .

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with the firm’s business model, that is, consistent with its established risk management objective and strategy. •

High effectiveness. While IFRS 9 does not lay down a specific method for determining hedge effectiveness, this determination must be consistent with the firm’s established risk management objective and strategy. Essentially, high effectiveness requires a high negative correlation between the hedged item and the related hedging instrument.

•

Designation must take place at the inception of the hedge.

Derivatives are valued at fair value under IFRS 9.

Benefits of hedge accounting: •

Gains and losses resulting from fair valuing derivative financial instruments not designated as hedges are included in net income. Hedge accounting reduces the resulting net income volatility.

•

For fair value hedges, net income volatility is reduced by fair valuing the hedged item, so that the fair value gain or loss offsets the fair value loss or gain on the hedging instrument. If the hedged item has declined in value, effective hedging can thus reduce or eliminate the effect on earnings of lower-of-cost-or-market or impairment test writedowns.

•

For cash flow hedges, hedge accounting reduces net income volatility by including gains and losses from fair valuing the hedging instrument in other comprehensive income until the hedged transaction takes place, at which time the gain or loss is transferred into net income.

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Under ideal conditions of uncertainty, the amount paid for an asset equals

its expected present value.

Expected present value of bonds on January 1, 2015: 5,000   500 10,500   0 PA0 = 0.7  + + 0.3 + 2  2 1.05 1.05  1.05 1.05  = 0.7(476.19 + 9523.81) + 0.3(4535.15) = 0.7 × 10000 + 0.3 × 4535.15 = 7,000.00 + 1,360.55 = 8,360.55

Vulture Ltd. paid $8,360.55 for the Volatile Ltd. bond investment.

b. Vulture Ltd. Balance sheet As at December 31, 2015

Cash

$500.00

Shareholders’ equity

at present value 10,000.00

Capital stock (PA0)

$8,360.55

Retained earnings

2,139.45

Investments,

$10,500.00

Note: present value of bonds at December 31, 2015

10500

𝑃𝐴1 = 1.05 = 10,000.00

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Vulture Ltd. Income Statement For the year ended December 31, 2015

Accretion of discount (8,360.55 × .05)

$418.02

Abnormal earnings Expected cash flow (0,7 × 500)

350.00

Actual cash flow

500.00

150.00

Increase in present value of bonds

1,571.43

Net income

$2,139.45

Note: Increase in value of bonds at December 31, 2015 calculated as follows 10500

5000

Original PA1 = 0.7 × 1.05 + 0.3 × 1.05 = 0.7 × 10000 + 0.3 × 4761.90

Revised PA1 =

= 7,000 + 1,428.57 = 8,428.57 10500 1.05

Increase in present value

= 10,000.00 $1,571.43

The bonds would be valued at amortised cost of $10,000 under IFRS 9, as per part b. Vulture’s net income for 2015 would be $2,139.45, as per part b. d.

Under IFRS 9, the bonds would be valued at fair value at December 31,

2015, with changes in fair value included in net income. The most reasonable estimate of fair value is their selling price on January 1, 2016 of $9,600. 262 .

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Vulture Ltd. Income Statement For the year ended December 31, 2015

17.

Interest income

$500.00

Increase in fair value of bonds: ($9,600.00 – 8,360.55 =)

1,239.45

Net income

$1,739.45

The average increase in cost of capital for firms affected by FIN 46 is

consistent with securities market efficiency if investors did not have enough information pre-FIN 46 to fully evaluate the extent of off-balance sheet activities, and resulting riskiness, of firms involved with VIEs. FIN 46 resulted in new, useful, information, either as a result of now consolidating VIEs or, for firms that avoided consolidation, by additional supplementary information. As investors realized the full extent of risk arising from these VIE activities, they reacted by bidding down share price, resulting in increased cost of capital, on average, for affected firms.

For those firms that avoided VIE consolidation through ELNs, the expanded disclosure requirements of FIN 46 were not sufficient for investors to evaluate fully the extent of the firms’ VIE activities and resulting risk (or firms deliberately complicated the wording so that it could not be fully understood). Thus rational investors underestimated risk for these firms, and their share price did not fall as much as it did for those firms that more fully revealed their VIE activities through consolidation.

Pre-FIN 46, behaviourally biased investors did not fully realize the

riskiness of firms affected by FIN 46 since firms’ VIEs were not consolidated. 263 .

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That is, such investors may not have bothered to fully interpret the supplementary information about VIE activities that firms provided pre-FIN 46. Following FIN 46, additional supplementary information about VIEs had to be reported by all firms subject to FIN 46. The new information was easier to understand, and investors realized that firms were riskier than previously believed. As a result, share prices were bid down on average and cost of capital increased.

While the finding that on average was that cost of capital increased for firms subject to FIN 46, this understanding was not complete since full understanding required careful reading of supplementary information, which behaviourally biased investors may not have done. It is easier for such investors to understand VIE information if VIEs are consolidated than if they are not consolidated, since risk is apparent from the consolidated balance sheet rather than buried in the notes. Consequently, post-FIN 46, behaviourally biased investors underestimated the riskiness of affected firms that did not consolidate relative to the risk of firms that did. Thus, cost of capital increased more for firms that consolidated.

Note: Behavioural biases consistent with this argument include: •

Limited attention.

•

Narrow framing, since investors may have economized on their mental effort by ignoring supplementary information.

•

Representativeness. The population of firms in the economy was reporting high earnings and relatively low risk leading up to the 2007-2008 market meltdowns. Investors may have assigned too much weight to similar evidence for high-earnings and high-risk firms that were affected by FIN 46, and thus failed to fully study their off-balance sheet activities.

•

Motivated reasoning. During the period leading up to the 2007-2008 market meltdowns, investors were used to receiving good financial statement news from firms in which they held shares. Obviously, they preferred good news to 264 .

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bad. Consequently, they ignored information about off-balance sheet VIE activities which would have revealed bad news such as high risk.

The FASB and IASB have responded with new (converged) standards to

further tighten requirements for VIE consolidation. Thus IFRS 10 (ASC 810-10 in the U.S.) requires consolidation when the firm bears risk from its VIEs and has power to control them. Thus, transferring a majority of profits and losses (and thus risks) to an outside party (i.e., creating ELNs) would not free the firm from consolidating as long as it retained some risk and also the power to control the VIE’s activities. IFRS 12 also requires even more supplementary disclosure, such as a judgments made in determining if the firm retains control, and additional information about any unconsolidated entities.

18.

EnCana must not have designated the hedging instruments as hedges, or

perhaps did not fully follow the procedures required for designation. The hedging instruments fell in fair value because the market prices of oil and gas (the hedged item) increased. IFRS 9 requires EnCana to account for its hedging instruments at fair value. In the absence of designation, there is no deferral of loss in fair value of the hedging instrument to other comprehensive income (cash flow hedge).Thus, the resulting writedown of hedging instruments creates the reported loss in net income. b.

Under IAS 39 and SFAS 133 (now ASC 815-30-35), financial instruments

designated as hedges of anticipated transactions (cash flow hedges) are valued at fair value, consistent with EnCana’s accounting. However, unrealized losses on such financial instruments are included in other comprehensive income, not in net income. These losses will be transferred to net income in future periods when the hedged oil and gas sales take place, offsetting the effects of higher oil and gas prices.

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Reasons why firms hedge at least part of their price risks of future anticipated sales: •

To manage price risk to a level desired by the firm.

•

To reduce firm-specific risk, as an alternative to investor diversification. This would especially be the case if the firm does not fully accept securities market efficiency and the rational decision theory that underlies efficiency.

•

The firm may feel that reporting on its risk management (i.e., hedging) strategies will reduce investors’ estimation risk. IFRS 7 requires extensive disclosures of the firm’s risk management (hedging) activities. This reduces inside information about these activities, thereby reducing investor concern about insiders’ information advantage (adverse selection problem).

•

To ensure that sufficient cash is available for planned major expenditures, such as capital projects and acquisitions. Financing capital projects from internally generated resources is more attractive to the firm the greater are investor concerns about estimation risk, which increase the cost of raising funds in the capital market. Investor concerns can arise from fear that, because of management’s inside information, new securities may be overpriced, leading to a lemons problem.

Note: Additional reasons, not yet covered in text: •

To reduce variability of management cash bonuses, where these depend on reported net income.

•

19.

To reduce probability of violation of debt covenants.

The price of crude oil must have risen subsequent to CNRL’s entering into

the cash flow hedging contract. Since a cash flow hedge enables CNRL to sell its 266 .

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future oil and gas production at a designated price, any rise in oil and gas prices above this price reduces the fair value of the hedging contract.

Like most derivatives, hedging instruments have to be fair-valued, However, since CNRL did not meet hedge accounting requirements, gains and losses from adjusting hedging instruments to fair value are included in net income rather than in other comprehensive income. Hedge accounting requirements include designation as a hedge by management, supporting the designation by appropriate documentation, consistency with the firm’s risk management strategies, and high hedge effectiveness.

Under the hedging standards, financial instruments designated as hedges

of anticipated transactions (cash flow hedges) are valued at fair value. Unrealized losses on cash flow hedges are reported in other comprehensive income until the hedged oil and gas production is sold in a future period. Then, the loss is transferred from other comprehensive income to net income, to offset the higher sales proceeds received by CNRL.

A reasonable answer is no. The loss on hedging reported by CNRL is the

result of a timing difference, which will reverse when the hedged product is sold in a future period. Since cash flow is not affected, the reporting of the loss is not decision useful given full disclosure.

A counter-argument, however, is that the loss suggests a lack of sophistication in CNRL’s risk management strategy. Why was the hedge not designated and accounted for so as to obtain the benefits of hedge accounting? This lack of sophistication may extend to other aspects of CNRL’s operations. Consequently, information about the loss may be decision useful with respect to the quality of management and CNRL’s corporate governance.

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Also, the large loss may suggest that management is engaging in speculation, possibly hidden by poor disclosure.

20.

Relevance is higher under fair value accounting than under historical cost.

From an asset point of view, the fair value of Blackstone’s carried interest option conveys information about the amount of cash expected to be received. This information is relevant to assessing the future performance of Blackstone. Under historical cost accounting, carried interest is recorded only as it is earned based on the earnings of the subsidiary company. No value is attached to the carried interest expected to be received.

A similar conclusion results from a revenue recognition point of view. Fair value accounting, by recording revenue at acquisition of the carried interest rights, gives the investor an earlier reading on prospective cash flows than does historical cost accounting. This can be seen in the $595,205 of additional earnings that would have been reported for 2006 under the proposed accounting.

Fair value accounting is less reliable than historical cost. Inputs into valuation models, such as Black/Scholes, are subject to error and possible manager bias, particularly since the companies that Blackstone invests in will typically be taken private. Under historical cost accounting, recognition of revenue is delayed until the investee companies report their earnings. At this time, amounts to be received are less subject to error and bias.

Reliability of fair valuation will be increased, however, if Blackstone commits to provide full disclosure of the estimation procedures it uses to determine how the fair value of its carried interest assets is calculated. Then, investors will be better able to determine the reasonableness of the fair value calculations, thereby reducing estimation risk. Note that Blackstone has an incentive to commit to supply this information since lower estimation risk will increase the market value of its share issue. 268 .

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A further increase in reliability can be achieved by disclosing risk information, such as a sensitivity analysis of fair value to various parameter assumptions.

Whether or not fair value accounting is more decision useful than historical cost depends on the investor’s evaluation of relevance versus reliability. This evaluation should take the extent of Blackstone’s full disclosure into account.

Volatility will not matter if the investor is risk neutral. Consequently, we

assume risk aversion, in which case increased risk will lower the amount the investor will pay for the shares, since risk averse individuals trade-off risk and return. The question then is, do more volatile earnings increase investor risk? The following points should be considered: • Blackstone’s cash flows will not be affected by its choice of accounting method. • Blackstone’s beta will not be affected by increased earnings volatility if markets are efficient, since the market will see through the earnings volatility to realize that choice of accounting method will not affect the covariance of return on Blackstone shares with the return on the market portfolio. • To the extent that investors in Blackstone’s new issue are diversified, and the earnings volatility from the proposed fair value accounting is firm specific, concern about earnings volatility is reduced a priori.

These points suggest that earnings volatility should not affect Blackstone’s share price. However, earnings volatility could have an effect to the extent investors are not rational. For example, investors subject to limited attention may not realize that earnings volatility does not necessarily translate into cash flow volatility. Such investors would perceive additional risk, which could lower share price.

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It thus seems that the effect of increased earnings volatility on the amount an investor pays for Blackstone’s shares depends in a complex way on extent of investor risk aversion, rationality, and market efficiency.

Note: While not yet introduced in this book, arguments that volatile earnings increase the probability of debt covenant violation and increase manager’s compensation risk, both of which affect share price, can be made.

Possible reasons why Blackstone changed its mind:

c. •

Concern about reliability of the proposed accounting, which could reduce decision usefulness for investors if sufficiently great.

•

Concern about earnings volatility, particularly if Blackstone did not fully accept investor rationality and market efficiency.

•

Concern about the adequacy of models, such as Black/Scholes, to value its carried interest assets.

•

Concern that investors will view its proposed accounting as aggressive, which could increase estimation risk and lower share price.

•

Concern about investor lawsuits should reported earnings fall due to a fall in fair value of carried interest assets. This could result from rising interest rates, for example.

21.

Country G will receive $15,000 per period for 3 periods. As at December

31, 2010, it expects to pay variable rate interest at 5%, or $10,000 per period. Thus it expects to receive $5,000 net each period. Fair value of the swap is the present value of these net receipts: 𝑃. 𝑉. =

5,000 5,000 5,000 + + 1.05 1.052 1.053

= 4,762 + 4,535 + 4,319

= 13,616 270 .

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The upfront payment is a liability of Country G, since under the contract it

is obligated to pay 2 years of airport landing fees and lottery proceeds to the financial institution, following the expiry of the swap contract. Strictly speaking, the liability should be recorded at fair value. However, at the time the swap contract is entered into, these amounts are not known. Given that each party has bargained at arms length, the $13,616 is a reasonable estimate of this fair value. Additional Problems 7A-1. While ceiling tests for all capital assets were not yet in place in the United States in 1992, the SEC did enforce a ceiling test on the oil and gas reserves of producers. Essentially, a write-down was required if the book value of reserves exceeded their present value. An article entitled “Natural-Gas Producers Bristle at ‘Snapshot’ Accounting” appeared in The Wall Street Journal on April 17, 1992. It described the annoyance of affected firms, some of whom were forced to make substantial writedowns as a result of the ceiling test. The SEC’s ceiling test required corporations to value their energy reserves at a price that “is whatever the company is able to sell its gas or oil for on the last day of the accounting period.” According to the article, the SEC states that this test is necessary in order “‘to insure that investors receive disclosures based on accounting that reflects recoverable value of assets.’” However, Bob Alexander, president of Alexander Energy Co., feels that this is not a good rule because “‘the ceiling calculation takes a snapshot of a price on one day.’” Mr. Alexander, along with others, feels that this rule should be replaced by “a 12-month weighted average price to eliminate seasonal fluctuations.”

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Not all companies were required to use the SEC ceiling test on their oil and gas reserves. Firms that used successful efforts accounting for costs of oil and gas exploration wrote off costs of unsuccessful wells, while firms using full cost capitalized them into the cost of successful wells. The SEC test was only for those companies that used full-cost accounting. Companies that use successful efforts accounting for proved reserves were subject to the ceiling test under SFAS 144. If the book value of oil and gas reserves was higher than the ceiling calculation, the company must write down the reserves to the ceiling. The article, for example, states that Enserch Exploration had to take a $50 million write-down of its reserves in 1991. These large write-downs often lead to a decrease in stock price even though it is a non-cash adjustment. Analyst Catherine Montgomery “believes the market sometimes reads too much into the write-downs,” adding “I think that serious investors, institutions and analysts understand these writedowns.…But the average investor out there has a knee-jerk response and stock prices may be affected.” Required a.

Explain why firms using the full-cost method of accounting for reserves are

more likely than successful-effort firms to be affected by the ceiling test. The article stated that full-cost firms “have to apply the ceiling test to their oil and gas reserves every quarter; successful efforts users never do.” Do you agree that successful-effort firms never have to apply a ceiling test? Explain. b.

Evaluate a claim made in the article that ceiling test write-downs can

adversely affect stock price. Do you agree with this claim? Explain. c.

The article pointed out that once ceiling test write-downs are made, assets

cannot be written up again if prices recover. Presumably, this accounts for the concern expressed by oil company managers about “snapshot” accounting. Why do ceiling tests under U.S. GAAP impose write-downs but not allow subsequent 272 .

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write-ups? As an informed investor in the oil and gas industry, would you support regular adjustment of book values of oil and gas reserves to fair value? Explain.

7A-2 As mentioned in Theory in Practice vignette 7.5, JDS Uniphase Corporation reported a preliminary loss of $50.558 billion for the year ended June 30, 2001. In a July 26, 2001, news release accompanying its financial statements, JDS also presented a “pro-forma” income statement that showed a profit for the year of $67.4 million. The difference is summarized as follows ($ million):

Net loss, as reported

$50,558.0

Add: Write off of purchased goodwill

$44,774.3

Write off of tangible and intangible assets from acquisitions

5,939.2

Losses on equity investments

1,453.3

Gain on sale of subsidiary

(1,768.1)

Non-cash stock option compensation

385.6

Income tax

(158.9) 50,625.4

Pro-forma net income

67.4

Required a.

The purchased goodwill arose primarily from business acquisitions paid

for in shares of JDS Uniphase. In The Globe and Mail, July 27, 2001, Fabrice Taylor stated that in JDS’ case, “most of the goodwill on the books comes from overvalued stock.” In a separate article, Showwei Chu quotes a senior technology analyst as saying, “They paid what the companies were worth at the

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time.” While trading in the $4 range in 2001, JDS’ shares were trading between $100 and $200 when most of the acquisitions were made. i)

Assume securities markets are fully efficient. Does the $44,774.3 writeoff

of purchased goodwill represent a real loss to JDS Uniphase and its shareholders, given that no cash is involved? If so, state precisely the nature of the loss and who ultimately bears it. ii) Would your answer change if securities markets are subject to momentum and bubble behaviour? Explain. b.

What additional information is added to the publicly available information

about JDS Uniphase as a result of the supplementary pro-forma income disclosure? c.

Why did JDS Uniphase management present the pro-forma income

disclosure? d.

To the extent that investors accept pro-forma income as a measure of

management performance, how might this affect management’s propensity to overpay for future acquisitions? Explain. 7A-3 A serious problem with fair-valuing complex financial instruments was revealed by the 2007–2008 meltdown of markets for asset-backed securities (ABSs) and related financial instruments. The meltdown began in the U.S. mortgage market during 2007–2008. Many mortgage loans had been made to poor credit risks, who were unable to meet increased variable-rate mortgage payments due to rising interest rates or expiration of low introductory “teaser” rates. Due to a moral hazard problem, many of these mortgages had been granted with little or no investigation of borrowers’ financial positions, and statements made by borrowers as to their incomes, credit histories, etc. were frequently not verified. 274 .

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Mortgages issued by mortgage lenders were packaged into ABSs. Many of these ABSs were in turn repackaged into collateralized debt obligations (CDOs). A typical CDO consisted of a series of tranches of increasing credit quality, where each tranche consisted of ABSs. Losses from mortgage defaults would be charged initially to the lowest quality CDO tranche. If this tranche was exhausted, losses were charged to the next lowest tranche, and so on. A claimed advantage of this mortgage securitization was that credit risk was dispersed across many different mortgages. Given low interest rates at the time and buoyant housing markets, it was felt that few homeowners would default. As a result, the tranches, particularly the higher-quality ones, were viewed as low risk, particularly since they received high ratings from credit rating agencies. Also, credit default swaps, which were essentially insurance policies hedging credit losses, further bootstrapped credit quality. Many of these CDOs were purchased by large investors such as banks, hedge funds, and mutual funds, including funds in Europe and elsewhere. Other major CDO purchasers included variable interest entities (VIEs), also called “conduits.” These VIEs were often sponsored by banks, which would transfer their CDOs and other ABSs to them. As described in Section 1.3, sponsors were able to avoid consolidation of VIEs by means of expected loss notes. To pay the sponsors for the CDOs they received, the VIEs issued asset-backed commercial paper (ABCP), which is short-term commercial paper secured by CDOs. While the interest rate paid by ABCP was low, it was higher than that of government treasury bills, another common short-term investment. Thus, ABCP was very popular as a vehicle whereby outside firms could temporarily invest excess cash. Other major ABCP purchasers included money-market mutual funds. The perception of ABCP’s safety was enhanced because they also received top ratings from credit-rating agencies. As the ABCP matured, VIEs rolled it over by issuing new ABCP. VIEs earned profits from the spread between the interest earned on their CDOs and the lower 275 .

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interest they paid on their ABCP liabilities. In the absence of consolidation of their VIEs, sponsoring institutions did not have to worry about the effect of this ABCP borrowing on their own leverage ratios or required capital adequacy ratios. Thus, VIEs create huge amounts of CDOs and asset-backed securities, financing them with ABCP so as to reap the spread. As evidence (e.g., increasing default rates) that the U.S. mortgage market was in trouble grew in the months leading up to August 2007, concerns about the security of CDOs also grew. Matters came to a head when two hedge funds operated by Bear Stearns Co. in New York declared bankruptcy because of CDO losses. Shortly afterwards, on August 9, BNP Paribas, France’s biggest bank, halted redemptions of three of its mutual funds because it was unable to determine the fair value of the CDOs they contained. Several German funds followed suit. While CDOs and CDSs were, in theory, effective in dispersing risk, subsequent events revealed serious problems in application, which came back to haunt the creators of these financial instruments. Models used by financial institutions to control risk had not anticipated the effects of lack of transparency concerning the quality of the mortgages underlying CDOs. Once concern about mortgage defaults appeared, lack of transparency contributed to investors’ lack of confidence in all CDOs, leading to a situation whereby no one was willing to hold them (an extreme version of the lemons problem, Section 4.6.1). Thus, liquidity pricing ensued, leading to market collapse. Instead of dispersing risk, it seems that CDOs and CDSs had merely transferred it from credit risk to liquidity risk. Furthermore, as VIEs collapsed, their sponsors had to take the VIE’s assets back onto their own balance sheets, creating huge writedowns. Normally, asset writedowns would not be needed to the extent they were hedged by CDSs. However, amounts of outstanding CDSs, and CDO losses, were so large that they threatened the ability of the CDS issuers to meet their obligations (counterparty risk). Then, impairment tests kicked in and the banks had to write 276 .

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their CDOs down to fair value. This fair value was difficult to determine since the CDO market had collapsed. Well-working market values were not available, meaning that CDOs had to be valued as level 3 assets. The low reliability of such valuations further contributed to erosion of investor confidence, so that CDO values fell even further. Indeed, fair value accounting itself came under severe criticism by managers of many financial institutions affected by the meltdowns, and by politicians, who claimed that it made matters worse. Since ABCP was secured by CDOs, concerns about the security of ABCP also grew. Eventually no one would buy ABCP either. As a result, conduits were unable to roll over maturing ACBP, which spread the liquidity crisis to the shortterm credit market. VIE sponsors were typically required by contract to repay the ABCP holders if the VIE could not. Many sponsors had to sell other assets to obtain the needed cash to pay off ABCP holders, also transferring downward pressure to stock markets. Central banks responded to these events by lowering interest rates and making it easier for banks and others to borrow funds. However, it quickly became apparent that the world financial system suffered from serious structural problems which would take some time to fully understand and fix. As part of the fix, governments worked to inject much needed capital into banks, by organizing takeovers and mergers, by buying banks’ impaired assets, and by direct equity investments. In this manner, it was hoped to build up confidence so that banks would resume lending. Other confidence building measures included increasing government insurance of deposits and money- market funds. Required a.

What was the moral hazard problem underlying the issue of mortgages?

Why was BNP Paribas unable to determine the fair value of its CDOs?

Why did CDSs not prevent the collapse of public confidence in CDOs? 277 .

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Why did the ABCP market collapse?

What did standard setters do in response to the criticisms of fair value

accounting for financial assets?

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Suggested Solution to Additional Problem 7A-1. a.

Since firms that use successful efforts accounting write off costs of

unsuccessful wells, while firms using full cost capitalize them into the cost of successful wells, the book value of oil and gas properties will be higher under full cost, other things equal. The higher is book value relative to a given physical quantity of reserves, the more likely it is that book value will hit the ceiling. Thus, while it is less likely that a successful efforts firm would have to apply the ceiling test than a full cost firm, the term “never” seems too strong. b.

Under efficient securities market theory, ceiling test write-downs would

only affect stock price if the write-down provided new information to the market. This seems quite possible, due to the inside nature of management’s estimates of reserves and their future proceeds, and the likelihood that information supplied by an ethical management is more reliable than information from other sources. Then, ceiling test writedowns would adversely affect share price. A counter-argument is that informed investors would monitor oil and gas prices and reserve quantities with particular care, using information from all available sources. Then, share price may already reflect the events leading to application of the ceiling test, in which case there should be little or no effect on share price. Another counter-argument is based on limited attention, prospect theory, and other theory and evidence that investors may not be fully rational and securities markets not fully efficient (Section 6.2). Given the complexities of fair-valuing oil and gas reserves, limited attention investors may not fully evaluate the information conveyed by the writedown, and could quite possibly overreact to the writedown. Also, according to prospect theory, investors may underweight the relatively high probability that prices will rebound, and may thus overreact to the writedown. If so, the oil companies’ claim that stock prices are adversely affected has some merit.

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The ceiling test standard is only a partial application of the measurement

perspective. It seems that the designers of the ceiling test were reluctant to completely abandon historical cost accounting for oil and gas exploration costs in favour of fair value. Such an accounting would run into the same problems of low reliability that beset RRA (Section 2.4). However, they recognized the potential for overstated asset values to mislead investors, possibly leading to auditor liability, should capital assets, including oil and gas reserves, be overstated relative to their fair value. A compromise solution is to draw on the concept of conservatism, and regard write-downs, once made, as establishing a new “cost” for the reserves in question. Consistent with historical cost accounting, this cost would not be subsequently written up if oil prices recovered. As an informed investor in the oil and gas industry, I would support regular adjustment of book values of oil and gas reserves to fair value if the increased relevance of the disclosure outweighed the decrease in reliability. However, if I am a rational investor, I would find supplemental information about the fair value of capital assets equally useful. But, if I have limited attention, and possibly some other behavioural biases, it would be less costly and more reliable for me to receive this information in the financial statements proper, since I would not have to conduct my own analysis of the supplemental information. Consequently, it is unclear whether or not I would support full fair value accounting. 7A-2 a. i)

Yes, the writeoff represents a real loss. If securities markets are efficient,

JDS’ shares fully reflected their value in the $100-$200 range relative to publicly available information at the time. The share prices of companies bought by JDS also fully reflected their value. Then, the decline in value of acquired companies represents a decline in the future performance prospects of JDS, including its acquired subsidiaries. This represents a real loss, borne by the JDS shareholders, including the former shareholders of the acquired companies who now own JDS stock. 280 .

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Note: An alternate argument can be made by drawing on the concept of opportunity loss. The shareholders have suffered an opportunity loss because they did not take advantage of the opportunity of selling their shares when they were selling in the $100-$200 range. ii)

Yes, my answer would change. Given momentum and bubble behaviour,

the shares of both JDS and its acquired subsidiaries were overvalued relative to publicly available information when the acquisitions took place. Then, the loss to JDS’ shareholders is because JDS paid too much to acquire its subsidiaries. It represents a correction of their overvaluation, brought about by the collapse of the bubble and momentum. The difference from part i, however, is that JDS’ future performance prospects are not affected. JDS’ shares are now valued at what they would have been had the bubble and momentum not occurred. The opportunity loss suffered by shareholders who did not sell their shares before the collapse still remains. However, their loss is due to failure to take advantage of the overvaluation, rather than necessarily to any reduction in JDS’ performance prospects. b.

The only possible additional information is a better evaluation of the

persistence of JDS’ earnings, through their selection by management to be added back to net income. That is, their selection for adding back may suggest that management views them as of low persistence. However, if the writeoffs leading to the $50.558 billion loss were fully disclosed in JDS’ 2001 financial statements, investors could evaluate their persistence there. If so, the additional information added is minimal or zero. c.

Two reasons for presenting the pro-forma disclosure are: •

To report JDS management’s estimate of its persistent earnings.

•

To take advantage of less than fully efficient securities markets, by presenting a positive earnings number despite the substantial loss in net income. 281 .

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Investors’ acceptance of pro-forma income will increase management’s

propensity to overpay for future acquisitions. If manager performance is evaluated by investors based on pro forma income, evaluation will be unaffected by any subsequent ceiling test writeoff of goodwill resulting from the overpayment. Thus, management has reduced incentive to avoid overpaying for an acquisition. 7A-3 a.

The moral hazard problem was that the original mortgage lenders would

typically package the mortgages into ABSs and sell them to other financial institutions. Since the mortgage default risk (i.e., credit risk) was transferred to others, there was reduced incentive for mortgage lenders to conduct due diligence.

Reasons why the fair value of CDOs was hard to establish by BNP

Paribas: •

Lack of transparency. This is likely the main reason for lack of a CDO market price. Since unobservability of CDO contents prevent investors from inferring CDO value, sceptical investors, concerned about all CDOs, will pool them all into a low quality category. Much like the market for used cars, investors viewed CDOs as lemons, and the market collapsed. It is difficult to value an asset when its contents are not transparent.

•

Market collapse. No market value for CDOs is available if they do not trade. Consequently, other, less reliable methods must be used to establish fair value. Even if there were trades, the market was likely very thin. CDOs may not be sold very often in a secondary market, particularly if they are held as security underlying ACBP.

•

Each CDO is more or less unique, since the specific mortgages or other assets it contains are unique to that CDO, even if the CDO contains assets of roughly similar quality. However, the particular assets contained in CDOs are not publicly observable, or at least very difficult to determine. Consequently, it is difficult to infer the market price of a CDO from the sale price of other CDOs (Level 2 valuation). 282 .

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Inadequacy of models. If a well working market value does not exist, models may be used to estimate fair value, perhaps based on historical mortgage default rates. However, it seems the models did not anticipate the high rates that developed.

•

Effects of CDS on CDO value. CDSs are designed to prevent loss to the CDO holder if underlying CDO assets fail. However, the market may not know the extent of coverage, or may be concerned about counterparty risk. As a result, the influence of CDSs on CDO market prices was unclear.

Reasons why CDS did not prevent CDO market collapse:

c. •

Partial coverage. CDOs, which are costly, may have covered only a portion of credit losses.

•

Volume of credit losses. If credit losses become very high, the CDS issuers may be unable to meet their obligations. CDO and ABCP investors may have been concerned about this possibility (counterparty risk).

•

Huge amounts of CDSs outstanding. It was not necessary to own the underlying reference CDOs in order to buy CDSs. Amounts of outstanding CDSs were often several times the value of the reference assets, since they were bought by speculators as well as firms that wished to insure their CDOs. This increased investors’ concerns that the CDS issuers would be unable to meet their obligations.

•

Other losses of CDS issuers. CDS issuers may well have invested heavily in CDOs and ABCP. Losses on these investments would further increase the likelihood that CDS issuers would not meet their obligations. CDO and ABCP investors may have also been concerned about this possibility.

•

Lack of transparency. To the extent investors do not know extent of coverage and the financial strength of CDS issuers, they would fear the worst and downgrade all CDS protection.

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The ABCP market collapsed because ABCP (short-term liabilities) were

secured by CDOs (longer-term assets). When the CDO market collapsed, conduits could not roll their ABCP over at maturity, since the market value of their security was worthless or almost so. Thus, the ABCP market also collapsed.

Standard setters issued stopgap revisions to financial instruments

standards to reduce the impacts of fair value accounting. One revision was that when market values did not exist and could not be reliably inferred from values of similar items, firms could determine fair value by using their own assumptions of future cash flows from the assets/liabilities, discounted at a risk-adjusted interest rate. This relieved firms from estimating how much a prospective purchaser would be willing to pay, when prospective purchasers were few and far between.

Also, the IASB revised IAS 39 to allow reclassification of certain financial assets. The intent was to make these standards more consistent with FASB standards, which allowed reclassification out of the fair value through profit and loss category in “rare circumstances.” The market meltdowns were deemed such a circumstance. Thus, financial assets valued at fair value could be transferred into loans and receivables. Here, they could be valued on a cost basis, even though fair value was lower, as long as discounted expected future cash flows from the transferred assets were greater than cost.

Also, standard setters began a series of revisions to accounting standards for financial instruments, derecognition of assets transferred to another entity, and consolidation of off-balance sheet entities. The intent is to simplify the accounting for financial instruments and to plug weaknesses in existing derecognition and consolidation standards that allowed accounting abuses leading up to the market meltdowns to develop.

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CHAPTER 8 THE EFFICIENT CONTRACTING APPROACH TO DECISION USEFULNESS 8.1

Overview

8.2

What is Efficient Contract Theory?

8.3

Sources of Efficient Contracting Demand for Financial Accounting Information

8.4

8.3.1

Lenders

8.3.2

Shareholders

Accounting Policies for Efficient Contracting 8.4.1

Reliability

8.4.2

Conservatism

8.5

Contract Rigidity

8.6

Employee Stock Options

8.7

Discussion and Summary of ESO Expensing

8.8

Distinguishing Efficiency and Opportunism in Accounting

8.9

Summary of Efficient Contracting for Debt and Stewardship

8.10

Implicit Contracts 8.10.1 Definition and Empirical Evidence 8.10.2 A Single-Period Non-Cooperative Game 8.10.3 A Trust-Based Non-Cooperative Game* 8.10.4 Summary of Implicit Contracting 8.11

Summary of Efficient Contracting

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LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

To Understand what Contract Theory is, and What it Wants to Accomplish

This chapter begins the second major component of the text, namely to consider management’s role in financial reporting, and how managers can be motivated to manage in the interests of firm investors. Suggested points to consider; •

Managers, like investors, are assumed to be rational, that is, to act in their own best interests.

•

The moral hazard problem. In our context, this arises because manager effort in running the firm cannot be observed by outside investors. As a result, the interests of rational managers conflict with the interests of investors, since the manager may shirk on effort at investors’ expense. The question then is, how is this conflict resolved so that investors have reasonable trust that the manager is working on their behalf.

•

A manager who shirks on effort may cover up by managing earnings so as to hide or delay the effects of his/her shirking on firm profitability This unfairly increases the manager’s reputation and compensation beyond what he/she deserves. Concept of an efficient contract. Firms enter into many contracts, in particular, debt contracts with lenders and compensation contracts with managers. By basing these contracts on accounting information, the manager’s temptation to act only in his/her own interests can be controlled. However, contracts can be costly to the firm (covenants in debt contracts, compensation paid to managers). An efficient contract motivates the manager to act on investors’ best interests at lowest cost to the firm.

•

Corporate governance. Efficient contracting is an important component of corporate governance. 287 .

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What Accounting Policies Support Efficient Contracting?

Contract theory gives considerable attention to lenders to the firm, since they are important sources of capital, and since debt contracts usually depend in some manner on accounting variables. To understand accounting policies desired by debtholders, the main point to realize is their payoff asymmetry. Debtholders do not share directly if firm profitability increases, but stand to lose if profitability decreases. From this, it follows naturally that debtholders prefer accounting policies that are reliable and (conditionally) conservative. They reward firms using such policies with lower interest rates. The most efficient debt contract balances the lower interest rate with the expected costs imposed by the debt covenants. With respect to shareholders, reliable and conservative accounting policies make it more difficult for the manager to record unrealized gains, thereby making it more difficult to hide shirking by inflating reported earnings so as to increase reputation and compensation. 3.

To Illustrate Economic Consequences

The text uses the saga of accounting for ESOs as an example of economic consequences, whereby managers expressed extreme concerns about an accounting policy that does not directly affect cash flows. Also illustrated are several of the opportunistic tactics used by managers to increase compensation by manipulating stock price so as to increase the value of their ESOs. Expensing of ESOs can then be viewed as a way to increase compensation contract efficiency. 4

To Review the Research on Manager Opportunism versus Efficient

Contracting Given the importance of efficient contracting to corporate governance, the question arises whether actual debt and compensation contracts are efficient or whether they bear evidence of manager opportunistic behaviour. This question has received considerable empirical research, much of which, but not all, suggests that on average, contracts are efficient. 288 .

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Instructors may wish to point out the parallel between this question and the question examined in Chapter 5 whether securities prices behave as predicted by rational investor theory and efficient capital markets. While the two concepts of efficiency are different, there is substantial empirical support for the respective theories. This leads into the argument in Section 8.7 that even though managers care about accounting policy choice even if it does not affect cash flow (contrary to market efficiency theory), the two theories are not inconsistent. However, some of the empirical evidence in Section 8.8, as well as the ESO saga, suggests that manager opportunism (i.e., inefficient contracts) is mixed in with the efficient contracts. The text uses this dichotomy to remind students that accountants have a responsibility to reduce the extent of manager opportunism by ethical behaviour leading to high quality financial reporting. 5.

To Introduce the Theory of Non-Cooperative Games

The text pushes the theme of contract efficiency a bit further by introducing a simple non-cooperative game example (by definition, no formal contract exists, therefore an implicit contract). This introduces the concept of a Nash equilibrium, and serves to illustrate nicely the basic conflict between investor and manager interests. Instructors who wish to pursue what happens when the game is repeated over time may be interested in the 2005 Nobel lecture by Robert Aumann referenced in Note 10 of Chapter 1. His lecture could be assigned for class discussion. I am grateful to a reviewer for suggesting this reference. Instructors who wish to consider non-cooperative games a bit further may be interested in the optional multi-period game illustrated in Section 8.10.3. I use this game demonstrate how important mutual trust is if cooperation between investors and managers is to be maintained (i.e., a more efficient implicit contract) over time. The role of accountants to help generate and maintain this trust is pointed out. To be honest, I have a reservation about this game. My reservation arises in the final period, where the investor must trust that the manager will play honest with some 289 .

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probability even though it is to his advantage to distort. If the investor feels he will distort for sure (rather than with probability 0.9 in this example), the game will unravel. This implies that the manager must value his reputation after the game is over. While this seems reasonable, it does go “outside the model” to some extent. Going outside the model for support does raise eyebrows in analytical modeling. The text returns briefly to game theory in Section 12.9.1, where the model of Darrough and Stoughton (1990) is discussed in the context of the trade-off faced by a manager between the role of full disclosure to reduce cost of capital and less disclosure in order to deter entry into the industry. Since Darrough and Stoughton, numerous researchers have studied the conflict between disclosure, threat of entry, and cost of capital. However, to pursue this literature, additional game theoretic concepts would need to be developed beyond the simple prisoner’s dilemma example in the text. The Darrough and Stoughton model is a 2-stage entry game with asymmetric information. For additional motivation, I usually hand out in class and discuss one or more articles from the financial press relating to game theory. Some interesting articles are: •

“It’s only a Game,” The Economist, June 15, 1996, p. 57.

•

“Nobel in Economics is Awarded to Three for Pioneering Work in Game Theory,” The Wall Street Journal, October 12, 1994, p. B12.

•

“How game theory rewrote all the rules, “Business Week, October 24, 1994, p. 44.

•

“Businessman’s Dilemma,” Forbes, October 11, 1993, pp. 107-109.

•

Economics Focus: “War games,” The Economist, October 13, 2005, pp. 82-83.

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

Maintaining a specified level of working capital generates lender trust by helping to ensure that the firm has the cash needed to pay interest and principal, since the firm is constrained from paying excessive dividends and manager compensation. To the extent that this covenant discourages additional borrowing (which would increase interest and principal payments), lender trust is further increased. Limiting the debt-to-equity ratio constrains the firm from issuing additional debt, which would dilute the security of existing lenders. Requiring the firm to maintain a specified times interest ratio also constrains the firm from additional borrowing. Also, should earnings fall, the firm is motivated to increase earnings, by cutting costs and/or increasing revenue. These covenants increase lenders’ trust, but do not give them complete trust because they do not guarantee that the firm will not become financially distressed. Also, despite conditional conservatism and numerous impairment tests, managers of financially distressed firms may have sufficient flexibility to manage earnings upwards to prevent or delay covenant violation.

Lenders benefit if the firm does well because the better the firm performs the greater is the probability that it will be able to pay interest and principal on its debts. Lenders are primarily concerned about downside risk due to payoff asymmetry. If the firm becomes financially distressed, lenders stand to lose heavily. However, if the firm does well the amount lenders receive does not increase. Rather, the only benefit is increased probability that they will in fact be repaid. 291 .

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To protect against downside risk, lenders want reliable financial information about the firm, and impairment tests to alert them to unrealized losses. Reliable information reduces the ability of management to manage earnings so as to artificially maintain covenant ratios and thereby reduce the lender protection these covenants provide. Impairment tests provide an early warning of unrealized losses. By reporting such losses, management and/or Boards of Directors are motivated to take actions to correct the operating policies that led to the losses. Also, to the extent impairment tests generate covenant violations, lenders are alerted to take steps to protect their interests, such as foreclosure, enforcing dividend restrictions, and preventing additional firm borrowing. 3.

Lev selected the date of the exposure draft because of efficient securities

market theory, which predicts that if the market is going to react to the imposition of successful-efforts accounting, it will do so at the earliest moment it becomes aware of this possibility. While the exposure draft did not impose successfulefforts accounting (this came later with the issuance of SFAS 19 in December, 1977), it was apparently the first solid indication the market had that the FASB was leaning towards successful-efforts accounting. In other words, the probability that successful-efforts accounting would be imposed increased substantially on July 18, and this was sufficient to trigger an efficient market reaction to the expected economic consequences. b.

The prospect of lower and more volatile reported profits for the concerned

firms increased the likelihood of violation of debt covenants. Alternatively, or in addition, lower and more volatile reported earnings threatened to reduce the expected utility of manager bonuses based on earnings. This could change how management operates the company. For example, a risk averse management might react to the greater volatility of earnings under successful efforts accounting by avoiding risky exploration programs. This would tend to lower program expected values and returns. Efficient securities market theory predicts that investors would respond to increased likelihood of covenant violation by bidding down share prices of 292 .

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affected firms. Share prices would also be bid down by diversified investors if the manager avoids risky exploration programs, since the effect is to lower expected returns without decreasing investor risk (since diversified investors have already diversified firm-specific risk away). Also, efficient securities market theory explains the rapid (3 day) share price reaction to the exposure draft. If an efficient market is going to react to an information event, it will do so quickly. c.

If investors have limited attention, they may not process all available

information in a timely manner. That is, it may take them some time to figure out and appreciate the economic consequences of switching to successful efforts. As a result, a reaction to the exposure draft would be expected, but it would take place over time as lower and more volatile earnings were reported, not on the day the exposure draft was released. An alternative answer is that if investors have limited attention they may not have noticed the exposure draft at all, even though the exposure draft was announced by the FASB and reported in the media. If so, there would be no effect on share prices until some time after the effective date of the standard, if, indeed, there was an effect at all. A delayed market reaction could also be driven by overconfident investors, who underreact to information that is not self-collected. Since the exposure draft was issued by the FASB and was public information, it was not self-collected. To the extent that the exposure draft conveyed bad news (lower and more volatile reported earnings), motivated reasoning would contribute to a lack of share price reaction. Investors who held shares of affected companies who were subject to motivated reasoning would tend to discredit the information conveyed by the exposure draft. Alternatively, herd behaviour may have actually contributed to the declines in price. Investors may have noticed a fall in affected firms’ share prices (perhaps 293 .

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driven by rational investors’ concerns about debt covenant and bonus plan considerations). They may have then “jumped on the bandwagon,” and rushed to sell, further driving prices down. Note: Instructors may wish to point out that in 1978 the SEC overrode SFAS 19 by Accounting Series Release 253 (1978). The FASB subsequently issued SFAS 25, allowing either method.

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Under contract theory, firms are motivated to minimize the firm’s contracting costs. One such cost arises from the fact that unforeseen circumstances may arise during the life of a contract. As an example, contracts often depend on accounting variables such as reported net income or debt-to-equity. When contracts are in force for a long time, it is difficult to anticipate changes in GAAP that might take place over the life of the contract and allow for them in the contract itself. As a result, if GAAP changes reduce reported net income and/or increase its volatility, this can induce technical violation of debt covenants, which imposes costs on the firm. Even if covenants are not violated, the probability of covenant violation sometime in the future may increase. Also, the amount and/or riskiness of manager compensation will change. If the manager has no flexibility of accounting policy choice, the manager may react by reducing R&D and maintenance costs, both of which may impose longer run costs on the firm. The manager may also reduce acceptance of risky projects, which, since less risk means lower expected value, imposes costs on diversified investors. If the manager has flexibility to choose accounting policies, contract efficiency may increase since he/she may be able to work out from under costs to the firm arising from debt covenants and compensation contracts by managing accruals or changing accounting policies, That is, allowing managers some flexibility to choose from a set of accounting policies can reduce expected costs to the firm of covenant violation and adverse manager reaction to reduced and/or riskier compensation. However, contract theory also predicts that firm managers may exploit their flexibility to choose accounting policies to act opportunistically. Then, they can use accounting policy choice so as to manage reported earnings upwards and/or delay public knowledge of bad news, in order to maximize their compensation and reputation, and to make life easier for themselves by minimizing the probability of technical violation of debt covenants. 295 .

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We may conclude that managers will prefer to have some accounting policy choice for both reasons. 5.

The following accounting policy choices are suggestive of what could be done to lower the probability of technical violation: (i)

Increase equity by increasing current reported (comprehensive) earnings.

This can be done by managing accruals. Possibilities include: • Minimize provisions for doubtful accounts receivable and for warranties. • If firm is subject to FASB standards, LIFO inventory method is allowed (ASC 330-10-30-9). If the firm uses this method, and if prices have risen since adoption, run down LIFO cost layers, or switch to FIFO. Both of these possibilities have problems, however. Running down inventory levels may interfere with operations. Also, if LIFO is allowed for tax purposes and prices are rising, increased taxes resulting from switching to FIFO would reduce cash flows. • Lengthen estimates of useful lives of capital assets, and/or, if currently using accelerated amortization, perhaps switch to straight line. • If property, plant, and equipment has increased in value, use the revaluation option of IAS 16 to record the asset at fair value. Note: This may increase equity volatility, since such revaluations must be kept up to date. • Sell surplus capital assets, such as land, used machinery and vehicles, subsidiary companies etc., to trigger a gain on disposal. • If the book value of financial instruments is less than their fair value, derecognize them, being careful to meet the requirements of IFRS 9 (transfer of substantially all risks and rewards of ownership and do not retain control). The gain on derecognition is included in net income. 296 .

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• Delay adoption of new income-decreasing accounting standards, or speed up adoption of income-increasing ones, to extent allowed by the standard. (ii)

Reclassify long-term liabilities as equity: • Argue that future income tax liabilities be excluded from debt for purposes of the debt/equity ratio calculation. • If allowed by GAAP, include minority interest in subsidiary companies as part of shareholders’ equity.

(iii)

Increase equity by increasing assets: • Defer advertising and R&D costs to balance sheet, to extent allowed by GAAP. For example, IFRS 3 allows capitalization of development costs.

(iv)

Decrease volatility of (comprehensive) income, hence of equity: • If an oil and gas company, switch from successful efforts accounting to full cost, if allowed under GAAP. • Under IFRS 9, adopt a business model that includes an objective to hold fixed-term financial assets in order to collect interest and principal. These can then be valued at amortized cost rather than at fair value.

(v)

Other possibilities include: If the firm is subject to FASB standards, use the fair value option (ASC 825-10-15), if possible, to fair value an asset that has increased in value or a liability that has decreased in value. The resulting gain is included in net income. Note: This tactic may increase future net income volatility.

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Conditionally conservative accounting (i.e., impairment testing) contributes to efficient debt contracting by providing an early warning system of financial distress. This increases the trust of lenders that any operating policies that have led to impairment will be corrected by management and/or the Board of Directors. Also, conditional conservatism, by creating a systematic understatement of net asset value, provides lenders with a lower bound on net assets to help them evaluate their loan security. Impairment tests also lower debt covenant ratios, providing additional security and protection for lenders. For example, tighter covenant constraints reduce the likelihood of excessive dividend and manager compensation payments and lower the likelihood of additional borrowing by the firm, all of which dilute the security of existing lenders. As a result of this increased protection and trust, lenders accept lower interest rates. Conditionally conservative accounting increases the efficiency of managerial compensation contracts by meeting a shareholder demand for reporting on manager stewardship. It makes it more difficult for managers to record unrealized income-increasing gains to enhance their reputations and compensation. Also, recording unrealized losses may motivate early manager action to correct operating policies that have led to such losses and, if they do not, alerting Boards of Directors to take timely steps to correct management’s lack of action.

From an efficient securities market perspective, the EnCana manager

need not be concerned. Given full disclosure, an efficient market will look through the increased earnings volatility and realize that there is no effect on cash flows. Furthermore, prior to the accounting standard change, the market would have known the amounts of foreign exchange gains and losses from financial statement information about U.S. denominated debt outstanding and knowledge about exchange rates—the 2002 changes did not add to what the market already knew in this regard. Consequently, there should be no effect on share prices or the firm’s cost of capital. Thus, if markets are efficient, then there should be no effect on its ability to lock in new financing at favourable rates. 298 .

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From the perspective of contract theory, The EnCana manager may be

correct to be concerned. Increased earnings volatility increases the probability of violation of debt covenants based on net income (such as debt-to-equity ratio and times interest earned), other things equal. Lenders will be concerned about the increased probability of violation and may be reluctant to lend at current rates. The firm may have to ask for less stringent covenants in new lending agreements, to keep the probability of violation at reasonable levels. However, less stringent covenants reduce lenders’ protection, again leading to higher interest rates. Manager concern would also arise if his/her compensation depended on reported net income. Then, increased earnings volatility may lead to increased compensation volatility. This reduces the expected utility of compensation for risk averse managers. Manage concerns would be enhanced if the set of allowable accounting policies available to the manager restricted his/her ability to manage earnings to offset their increased volatility. 8.

Contract theory predicts that oil companies will want to report high profits

sooner rather than later. This is because the managers of these companies would prefer high bonuses now rather than some time in the future, other things equal, since the present value of a dollar of bonus is higher the sooner it is received. Also, higher reported profits will reduce the probability of technical default on debt covenants, at least in the short run. Thus, the oil companies would be predicted to increase the price of gasoline and to avoid excessive reserves for environmental costs, maintenance and legal claims. b.

For a U. S. company, LIFO would be most effective in holding down

profits. On a rising market for crude oil, and assuming shortages do not unduly deplete inventory levels, LIFO will report a higher cost of gasoline sales than FIFO or average cost methods. 299 .

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Efficient securities markets theory predicts that the strategy would not be

effective, given full disclosure, since the securities market would see through the accounting policy choices that hold down reported profits. Indeed, the oil companies may well end up subject to greater political backlash than if they had not used accounting policy choice to reduce reported profits, since they would be open to charges of trying to hide their excess profits. However, several arguments suggest that the policy may be effective in reducing political backlash: • Given the theory and evidence that securities markets are not fully efficient, the market may not fully appreciate the extent to which accounting policy choices are driving down profits, particularly if gasoline prices are being held down at the same time. • It may be possible for the companies to disguise their earnings-reducing strategy by less than full disclosure. For example, it is not clear that provisions for maintenance programs would need complete disclosure. Even with full disclosure, good arguments can be made for environmental, maintenance and legal claims provisions, independently of the price of crude oil. • The efficient markets hypothesis applies primarily to investor and securities price behaviour. It is less clear that politicians and the general public would appreciate the impact of accounting policy choices on reported profits. One reason is simply that they may be less knowledgeable about accounting matters. However, a more fundamental reason is that they may have less incentive to dig into reported profits. Individual consumers may not be sufficiently affected that they will bother to go on the “warpath.” Politicians may be content with the appearance of lower profits if the public is not aroused, since otherwise they would have to confront a large and powerful industry.

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Thus, the strategy may well be effective. Any increase in the price of gasoline can be blamed on events outside the oil companies’ control and, if reported profits do not significantly increase, politicians and the public may accept the higher prices.

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Firms with large ESO plans buy back their stock on the market to counter

the dilution of current shareholder interests that ESOs cause. Since the exercise price of ESOs is below the market price of the underlying stock, large ESO issuances force down the price of all of the firm’s shares. While the buyback does not directly affect net income, the reduction in number of shares outstanding creates an increase in earnings per share. Dividend decreases due to larger number of shares outstanding may be prevented. In effect, the buyback helps to counteract the downward pressure on share price and dividends per share created by the ESOs. Note: Another reason for stock buybacks is to prop up share price by buying when stock price is low.

Yes, you would be concerned. The increase in earnings per share

resulting from this tactic may be transitory. Since share prices tend to increase over time, the firm is quite likely to have to pay more than current share price when it actually buys its shares later, even if it buys back the shares gradually. In effect, the amount of cash paid out will likely exceed the apparent amount of cash payout if all shares were bought back at the market price when the buyback is recorded. Less cash in the business will exert downward pressure on the firm’s future earnings. If so, and if you bought shares on the strength of the current earnings per share increase, share price may suffer later. 10.

Relevant information helps investors to estimate future cash flows from their investments. The relevance of Black/Scholes measures of ESO fair value is high, because of the dilution that ESOs create. The company receives less cash from issuing ESOs than it would receive if the shares were sold at their market value. Thus, there is less capital on which to earn a return, reducing future earnings accordingly. Also, future earnings and dividends are spread over more shares. Expensing ESOs lowers current reported net income, thereby anticipating the 302 .

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lower per share earnings and dividends to investors that ESOs create. We conclude that relevance of Black/Scholes as a measure is high. Representationally faithful (i.e., reliable) information is complete, free from material error, and neutral. • The Black/Scholes model is complete, since the parameter inputs into the model provide a theoretically correct representation of the determinants of option value. However, when applied to ESOs, completeness is reduced since the model does not allow for early exercise. That is, Black/Scholes applies to European options, whereas ESOs are American options, As a result, the determinants of early exercise are not included in the model. • Like any model, the parameter inputs into Black/Scholes require parameter inputs, including, in particular, variability of share price and time to expiration. These inputs are subject to error and possible manager bias. •

It is necessary to estimate ESO holders’ exercise strategy. The expected time to exercise that results can be substituted for the expiry date in the Black/Scholes formula. However, this estimate is subject to error and bias, particularly for firms with little past ESO history and/or few employees receiving ESOs.

• The following point is based on Note 10 of this chapter, and should be expected only from students with mathematical and statistical training: The Black/Scholes option value is often concave in time to expiry, particularly if issued with zero intrinsic value. Then, even if expected time to exercise is accurate, use of this expected value as time to expiry in the Black/Scholes formula will produce upwardly biased estimates of ESO value. We conclude that the reliability of Black/Scholes as an estimate of ESO expense is low. 303 .

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Some people claim that the cost of ESOs is zero because the firm does

not have to pay the recipients for their employee services. Indeed, some cash (i.e., the exercise price) is received instead. These claims are incorrect because they ignore the concept of opportunity cost. Issuance of shares by means of ESOs dilutes the equity of existing shareholders because the shares are issued at less than their market value. This cost shows up as less-than-proportionate future earnings and dividends received by existing shareholders. Ignoring this cost understates the cost of the firm’s employee compensation. c.

Managers may oppose the expensing of ESOs for the following reasons: • Managers of firms with debt covenants will be concerned that lower reported net income will increase the likelihood of covenant violation. • Managers with compensation contracts based on net income will be concerned about lower compensation. • To the extent that expensing ESOs leads to reduced use of ESOs as a compensation device, managers will not have as much scope to increase the value of their ESOs by, for example, timing of release of bad and good news, pump and dump, spring loading, and late timing. • Securities market inefficiency. To the extent that management believes that securities markets are not fully efficient, it is concerned that share price may fall and costs of capital rise as a result of lower reported earnings. • Relevance versus reliability. Managers may be concerned that the increase in relevance from expensing ESOs is outweighed by low reliability of ESO cost estimates. If so, earnings quality is reduced. This will lower the firm’s share price on an efficient market.

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A firm may voluntarily adopt ESO expensing for the following reasons: • Very large firms, who are often subject to political pressures due to high profits, may wish to lower the amount of reported net income so as to reduce political backlash. The voluntary adopters given in the question, such as Microsoft, are very large. • Little impact on reported net income. Some firms use ESOs more than others. Firms that do not issue very many ESOs can “afford” the impact of expensing. • To change compensation policy. A firm’s compensation committee may want to reduce or eliminate use of ESOs, particularly since they may encourage excessive risk taking. This concern is due to numerous instances where ESOs may have driven dysfunctional management practices leading to financial reporting scandals (e.g., Enron, WorldCom, backdating). Expensing ESOs may be a first step to reducing ESO use, since the firm can better point to the fact that ESOs do indeed have a cost. • Reputation. Some firms may want to build up a reputation for transparency and full disclosure, leading to high earnings quality. Voluntary adoption of improved financial reporting policies provides a signal in this regard. Note:

Reputation and signalling are not fully discussed in the text

to this point. 11.

Yes, the accusations are consistent with the findings of Aboody and

Kasznik (2000), assuming that the regular ESO awards were scheduled in advance so that the former Big Bear CEO knew they were coming, or had enough control over the compensation committee of the Board that he could control ESO timing. The former CEO could have chosen to feed the bad news to the market shortly before the ESO award date. Then, at time of award, share 305 .

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price would be low. By setting the ESO exercise price equal to share price at the grant date, the options would greatly increase in value when news that Blue Range had “sprung back” became known. b.

Deep-in-the-money ESOs are likely to be exercised early according to

Huddart’s (1994) analysis and the empirical results of Huddart and Lang (1996). Then, we would expect the Big Bear CEO to exercise them at, or shortly after, the time of the rebound. 12.

The answer depends on my risk aversion, my beliefs about the state of

the economy, my ability to evaluate the fair value of the debt, and the investment alternatives available to me. With respect to investment alternatives, I would be willing to invest in tranches of covenant-lite debt if safer debt, such as government debt and debt issued with covenants attached, offered a return less than the return offered on the covenant-lite tranches. I would be willing to bear greater risk in order to obtain a higher return. With respect to the state of the economy, the higher are my beliefs that the state is high, the more likely that I would be willing to invest in covenant-lite debt. This is because the higher the state of the economy, the less likely that firms will default on their debt, other things equal. I would be less willing to invest in tranches of covenant-lite debt to the extent that I am unable to evaluate the fair value of such debt. Evaluating fair value is more difficult, even impossible, unless there is transparency of reporting on the underlying debt components of the tranche. If the tranche is rated by a credit rating agency, my concerns about transparency would be reduced. However, lack of knowledge of the rating agencies’ valuation methodology, including the models they use, would leave me with some concerns even if the tranche is rated 306 .

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highly. These concerns would further increase if I was aware that rating agencies were hired and paid by the firms whose ABSs I was buying. With respect to my risk aversion, the greater it is, the less likely that I would be willing to sacrifice greater security on government and covenant-attached debt for a higher return. However, my risk will be reduced to the extent the tranche of covenant-lite debt in which I invest is spread over a large number of firms and different industries. Risk will be further reduced to the extent the tranche is protected by CDS. b.

The moral hazard problem is that if debts composing a tranche have no

covenants attached, the managers of firms issuing such debt may behave opportunistically by failing to protect the interests of the trancheholders. That is, managers have less motivation to maintain ratios that protect debtholders’ interests, such as debt-to-equity, interest coverage, and working capital. Such firms also have less incentive to avoid excessive dividends and subsequent issues of additional debt. Thus the likelihood that firms issuing covenant-lite debt will enter financial distress increases, reducing trancheholders’ security. c.

The reason is counterparty risk. During a severe market collapse, firms

issuing CDSs may face so many claims that they do not have the financial resources to honour them all. This is particularly the case if CDSs are ‘naked,” that is, speculators can buy CDSs without having to own a position in the underlying debt. Then, the amount of CDSs outstanding for a specific debt security may be several times the amount of the debt. 13.

Maintenance of a specified level of net worth is a way to reduce lenders’

risk, by providing a cushion of net assets available to them should the borrowing firm encounter solvency problems. This is also a way to control the moral hazard problem between lender and borrower, by limiting the payment of excessive dividends. As a result, the firm can borrow at a lower rate of interest than without such covenants. 307 .

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Managers of firms that issue debt may inflate current earnings to disguise

lenders’ concerns about the security of their loans and firm solvency. These concerns, which increase with the level of information asymmetry between firm and lender, leads to lenders demanding a higher interest rate. To the extent that the manager does inflate current earnings, the escalator clause raises the required level of net worth, thereby increasing security of lenders. As a result of this greater security, lenders accept a lower interest rate. By, in effect, accepting a motivation not to inflate current earnings, the firm enjoys lower interest costs. c.

The escalator clause increases the manager’s incentive to adopt

conservative accounting since conservative accounting lowers net income, thereby reducing the effect of the escalator clause. Lenders benefit from conservative accounting since conservatism introduces a downward bias to earnings and net worth, making it more difficult to pay excessive dividends, and increasing the protection provided by debt covenants. In effect, the escalator clause and conservatism work together since the escalator clause increases the motivation of the firm to adopt conservatism which, according to contract theory, benefits investors. Examples of conservative accounting include amortizing capital assets faster than their decline in value-in-use, expensing of research costs, and rigorous and timely application of lower-of-cost-or-market and impairment test standards.

14.

Problems of the Black/Scholes option pricing model applied to ESOs: • Black/Scholes assumes options are freely traded, whereas ESOs are not. Thus the value of an ESO to its recipient is less than that given by Black/Scholes. As a result, Black/schools tends to overstate ESO expense.

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• If the employee leaves the firm, ESOs are often forfeited. Also, for employees that stay, there may be requirements to hold any shares acquired from ESOs for some time after exercise. This reduces ESO value to the recipient. As a result, Black/Scholes tends to overstate ESO expense. • Black/Scholes assumes that the option is held to expiry, whereas an ESO can be exercised any time after vesting date up to expiry. Since early exercise sacrifices some upside potential of the ESO, the ESO is worth less to the employee than Black/Scholes. Again, Black/Scholes overstates ESO expense. b.

Not necessarily. Expensing ESOs increases relevance of earnings, since

expensing anticipates the reduction in earnings and dividends resulting from the dilution of existing shareholders’ interests that ESOs create. If the increase in relevance outweighs any decrease in reliability, the net effect is decision useful for investors. c.

The finding that firms with high implied share price variability were more

likely to disavow than firms with low implied share price variability suggests that disavowals are informative for investors. High share price variability leads to greater uncertainty about the ultimate ex post cost of ESOs to the firm. For risk averse investors, greater uncertainty lowers expected firm value. Disavowal of reliability helps to inform investors about this uncertainty. Note: An equally acceptable answer is to argue that if the manager wanted to opportunistically minimize the apparent value of his/her ESO compensation, he/she would be just as likely to disavow under low volatility as under high volatility. Higher likelihood of disavowal under high share price variability would not be observed. d.

A finding that management’s share price variability input to Black/Scholes

exceeded actual share price variability following the disavowal implies 309 .

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informativeness. If disavowals were opportunistic, managers’ variability inputs would be lower than actual, not greater, since lower variability input lowers ESO value, thus decreasing the manager’s ESO compensation expense and increasing reported earnings. The fact that a manager inputs a higher share price parameter, thereby increasing Black/Scholes ESO value, suggests that he/she actually believes ESO expense reliability is low and is willing to report higher ESO expense and lower earnings to support this belief. 15.

To the extent that going concern value is greater than liquidating value, it

becomes less likely that a delegated monitor will trigger liquidation, and more likely that all debtholders will receive timely and full repayment when the firm continues as a going concern. Reduced concern about inappropriate liquidation results in less demand by debtholders that the firm include a cross acceleration covenant in its debt contracts. In effect, the firm can obtain favourable borrowing costs without the necessity of cross acceleration. 2.

Lenders want timely warning of possible financial distress. They also want

the delegated monitor (the bank) to do a good job in monitoring the lender’s financial condition. Since the bank will base a decision to accelerate loan repayments on the covenants contained in its own loans to the firm, a greater number of such covenants suggests both that it intends to do a good monitoring job and that warning of financial distress will be timely. Also, since the bank will receive fees for its monitoring services, it may wish to signal its commitment to diligent monitoring by incorporating a large number of debt covenants in its own lending agreements. In both cases, lenders will perceive higher expected value of their loans and will thus be willing to grant better loan terms. As a result, the firm has a greater incentive to include cross acceleration in its debt contracts. 3.

As information asymmetry increases, firm performance is harder to

evaluate. Estimation risk increases and investors lower the price they are willing to pay for securities, including debt securities. A bank is in a position to demand 310 .

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inside information from the firm, and can thus do a better job than investors of monitoring the borrower. Since lenders want assurance that the bank will demand accelerated loan repayments only when necessary, the greater the information asymmetry, the more they value the bank’s access to this inside information, and the less they raise the interest rate and other debt terms that they demand. Thus, the greater the information asymmetry, the greater the resulting incentive for the firm to include cross acceleration in its debt contracts. 4.

The higher are the borrowing firm’s discretionary accruals, the greater the

information asymmetry between borrower and lender. Given the presence of a cross acceleration provision, the authors of the study point out that much of the information that the delegated monitor, that is, the bank, demands when making a liquidation decision is in the form of accounting-based debt covenants. To the extent that the bank has less confidence in the values of these covenants due to information asymmetry, the likelihood of inappropriate liquidation increases. Lenders respond by demanding a higher interest rate. 16.

The predicted outcome is that both parties play strong.

Yes, (strong, strong) is a Nash equilibrium. Each player has an incentive

to play strong, given that the other player chooses strong. For example, if the standard setter plays strong, the corporations receive a higher payoff from playing strong (12) than playing cooperate (8). Similarly, if the corporations play strong, the standard setter is better off to also play strong since its payoff is lowered from 15 to 10 if it cooperates. c.

Both parties would be better off if they cooperated, rather than each

playing strong. However, if the corporations play cooperate, the standard setter will reason it would be better off to play strong, thereby raising its payoff from 30 to 40. In the absence of a binding agreement or government legislation that would force the standard setter to cooperate, the (cooperate, cooperate) strategy is likely to break down. This strategy is not a Nash equilibrium.

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The cash flows to each player are as shown in the payoff table: Management Do not manage

Manage

earnings

Bonus plan

100, 50

80, 60

No bonus

110, 30

70, 30

Shareholders

plan

The first number in each box represents the payoff to shareholders. Note that cash flows to shareholders are net of compensation paid to management. Note also that if management manages earnings, the cash flows to shareholders are less than if management does not manage earnings. This is because under the manage earnings alternative, management works less hard–it increases reported earnings (but not cash flows) by manipulating accruals rather than by working hard. b.

A Nash equilibrium is (bonus plan, manage earnings).

Note that the manager is indifferent between managing and not managing earnings if the shareholders play no bonus plan. If we assume that management would then choose the pure strategy desired by the shareholders, a second Nash equilibrium is (no bonus plan, do not manage earnings). c.

The main advantage is that the conflict situation between management

and shareholders is formally modeled. This gives us a better understanding of the process of earnings management, because both management’s reaction to the shareholders’ bonus plan decision and the shareholders’ reaction to 312 .

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management’s earnings management decision are simultaneously taken into account. In single-person decision theory, in deciding on which act to take, shareholders would have to assign probabilities to management’s possible actions of managing or not managing earnings. Similarly, in deciding whether not to manage earnings, management would have to assign probabilities to the granting /non-granting of the bonus plan. That is, managing/not managing earnings and granting/not granting the bonus plan, respectively, are states of nature in a decision theoretic formulation of the problem. In a valid single-person decision problem, state probabilities must not depend on the action chosen. This is not the case here, since the action chosen by the shareholders will certainly affect the probability of what management does, and vice versa. That is, a singleperson decision theory formulation does not capture the players’ strategic reaction to the other player’s action choice. Thus, predictions about what might happen here, if based on the single-person decision theory model, are unlikely to be as accurate as if based on the game theory model, and we would be less likely to understand what is really going on. Note: A complication with the game-theory approach, however, is that there may be more than one Nash equilibrium. Then, the prediction of the game-theory approach is less clear. 18.

The Nash equilibrium is do not invest, work for manager. This is the only

strategy pair such that, given the strategy choice of the other player, neither player has an incentive to change strategies. b.

The cooperative solution is invest, work for investor. In this strategy, both

players are better off than in the Nash equilibrium. The cooperative solution is unlikely in a single play because if the investor invests, the auditor will move to work for manager. Anticipating this strategy, the investor does not invest. c.

Three possible ways to attain the cooperative solution: 313 .

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The investor and auditor could enter into a binding agreement to play the cooperative strategy.

•

Ethical behaviour by the auditor, reinforced by the auditor’s professional association and longer-run reputation considerations, may motivate the auditor to work for the investor despite the higher one-shot payoff of working for the manager.

•

Change the payoffs of the game. For example, if the investor invests, a penalty of 4 for working for manager would lower the auditor’s payoff to, say, 2. Then, the auditor would move to work for investor. Increased regulations following the Enron and WorldCom scandals, such as Sarbanes-Oxley, may have this effect.

19.

Three (pure strategy) Nash equilibria are (Violate, Keep), (Keep, Violate)

and (Violate, Violate), where the first word within brackets denotes country 2's strategy. The (Keep, Keep) strategy is not a Nash equilibrium because both countries would prefer to move to Violate b.

Country 1 could switch to Violate, thereby punishing country 2 for not

playing Keep. When the game is repeated, each of the players realizes that it is to their mutual benefit to play (Keep, Keep). This is because each country will perceive that if it violates, the other country can punish it by switching to violate at the next opportunity, that is, in the next period. Thus, both countries seem to have an incentive to play (Keep, Keep). But, this reasoning breaks down in the last period. At the beginning of the last period, both players realize that it will not be possible for the other party to punish a switch to violate. Thus they both have an incentive to switch strategies in the last period, in which case the payoff is (50, 50). Now, consider the second-last period. Knowing what will happen in the last period, each player will realize that it will not be possible for the other party to punish violation taking place in the second-last period, since both will be violating 314 .

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in the last period anyway. Thus, each party has an incentive to switch to violate in the second-last period. This reasoning works backwards each period to the current one. Any attempt at cooperation unravels and the predicted strategy pair is (Violate, Violate) in each period. Note that an inability to enter into binding agreements is crucial to this argument. c.

If the game is repeated indefinitely, the above unravelling argument

breaks down, since there is no last period. Then, a likely outcome of the game, even though the game is non-cooperative, is the strategy pair (Keep, Keep). Note: This conclusion is a consequence of the folk theorem of game theory. See Chapter 1, Note 23.

Additional Problems 8A-1 Accounting standards such as IAS 19 require current value accounting for other post-employment benefits (OPEBs). Under IAS 19, OPEBs expense includes the change in the discounted present value of expected future payments to employees. Similar provisions exist under FASB standards, where SFAS 106 (1990) (now ASC 715-60) was the original current value accounting standard in this area. . Prior to these standards, most other post-employment benefits were accounted for on a cash basis, allowing companies to expense these benefits as they were paid to employees. 315 .

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These new standards created economic consequences, whereby firms moved to reduce their postretirement benefits. For example, as reported in The Wall Street Journal (November 4, 1992), McDonnell Douglas Corp. cut benefits to retired employees upon realizing that it faced a $1.2-billion charge against earnings from SFAS 106. Required a.

What is the after-tax impact on a firm’s cash flows following adoption of

current value accounting for OPEBs, assuming benefits are not cut? b.

Why would some firms move to reduce retiree benefits following adoption

of current value accounting for OPEBs? c.

Give an argument for how a firm’s share price might rise following the

reporting of a major charge from adopting current value accounting for OPEBs.

8A-2. The instability of economic cartels such as OPEC (Organization of Petroleum Exporting Countries) can be explained, at least in part, by game theory considerations. Typically such cartels attempt to agree to restrict oil production and keep prices to customers high. Frequently, however, some countries violate these agreements.

Required Use the following depiction of a two-country non-cooperative game to explain why violation occurs. That is, explain in words which strategy pair is likely to be played in this game and why. Identify the Nash equilibrium of this game.

Country 1

Keep 316 .

Keep

Violate

100, 100

40, 200

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Country 2 Violate

200, 40

50, 50

In each box, the first number represents country 2’s payoff and the second country 1’s payoff.

(CGA-Canada)

8A-3. Non-cooperative game theory is a way of modelling the conflict situation that exists between a firm manager and investors. Consider the following depiction of a game between a manager/entrepreneur and a potential investor in the firm.

Manager/Entrepreneur Work hard

Shirk

Invest

7, 6

2, 7

Do not invest

5, 3

6, 5

Investor

The manager may choose to work hard or shirk. The number pairs show the payoffs to the investor (first number) and the manager (second number) for each manager/investor strategy pair. For example, if the investor invests and the manager works hard, they receive payoffs of 7 and 6 respectively. Required a.

Identify the cooperative solution and explain why it is not a Nash

equilibrium. b.

Identify a Nash equilibrium and explain why it is the predicted outcome of

a single play of the game. Suggested Solution to Additional Problems 317 .

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This would depend on the tax deductibility of the accruals for other

postretirement benefits. If these are not deductible, there would be no effect of OPEB standards on cash flows following their adoption, to the extent the company continues to pay these benefits. If the accruals are tax deductible, this would increase after-tax cash flows, at least in the short run. After a few years, when the new accounting approaches “steady state,” accruals and cash payments for benefits may be approximately equal, in which case the after-tax cash flow effects would be minimal. b.

The answer is not completely clear, since the OPEB standards do not

increase amounts of benefits. One possible reason is that firms did not realize how much other postretirement benefits were costing them until the expenses generated by the new accrual accounting became apparent. Another possibility is that firms were quite aware of these costs and were using the major liabilities recorded under the OPEB standards as an excuse to cut benefits. Then, the benefit cuts can be blamed on the accountants rather than the firm itself. c.

Share price would rise, given efficient securities markets, if it became apparent

that firms' cash flows and future reported profitability would increase. This could result from a cut in benefits following implementation of the OPEB standards, unless the cuts seriously eroded employee motivation. Share price would also rise if the amount of the accrued OPEB obligation was less than the market had expected. 8A-2. The payoff table for the two-country, non-cooperative game, repeated here for convenience, is:

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Country 1

Country 2

Keep

Violate

Keep

100, 100

40, 200

Violate

200, 40

50, 50

The first number in each box represents country 2's payoff. To see why violation of the keep/keep agreement may occur, we see that if country 2 keeps but country 1 violates, country 1 receives a payoff of $200. Thus, country 1 has an incentive to violate the keep/keep agreement. Similar reasoning applies to country 1. However, if one or more countries violate, the cartel agreement has broken down, other countries will also violate, and each country ends up with $50. The (50, 50) payoff is the Nash equilibrium of the game. While both countries would be better off if they both played a keep strategy, by doing so, each country is tempted to violate the cartel agreement. If they both violate it, they end up at (50, 50). 8A-3. a.

The cooperative solution is (invest, work hard). This is not a Nash

equilibrium, however. Since it is assumed that the parties do not agree to cooperate, the manager will change his/her action to shirk, thereby receiving a payoff of 7 rather than 6. The definition of a Nash equilibrium is that neither player has an incentive to change his/her action, given the action of the other player. Thus the cooperative solution does not meet the definition of a Nash equilibrium. b.

The Nash equilibrium solution is (do not invest, shirk). If the investor

invests, the manager’s highest payoff is given by shirking. If the manager shirks, the investor’s highest payoff is given by not investing. Thus, without an 319 .

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agreement to cooperate, neither player has an incentive to change his/her act given the act of the other player. This is the definition of a Nash equilibrium.

320 .

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CHAPTER 9 AN ANALYSIS OF CONFLICT 9.1

Overview

9.2

Agency Theory 9.2.1 Introduction 9.2.2 Agency Contracts between Owner and Manager

9.3

Manager’s Information Advantage 9.3.1 Earnings Management 9.3.2 The Revelation Principle* 9.3.3 Controlling Earnings Management 9.3.4 Agency Theory With psychological Norms*

9.4

Discussion and Summary

9.5

Protecting Lenders from Manager Information Advantage

9.6

Implications of Agency Theory for Accounting 9.6.1 Is Two Better Than One? 9.6.2 Rigidity of Contracts

9.7

Reconciliation of Efficient Securities Market Theory with Economic Consequences

9.8

Conclusions on the Analysis of Conflict

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 321 .

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To Introduce Fundamental Concepts of Agency Theory

In my outline of agency theory, note that the payoff from the manager’s current effort is not realized until after the single-period contract expires. However, the agent must be compensated at period end. This allows net income to be viewed as a performance measure upon which compensation is based, leading naturally to consideration of the ability of net income to predict the payoff, and the properties it needs to be a good predictor. Section 9.2 covers much of the basics of agency theory. Instructors who wish only to develop the basic moral hazard problem of owner and manager, and why actual executive compensation contracts are based, at least in part, could stop here. However, Section 9.6 is useful in explaining why these contracts also depend on stock price performance. This section also explains, using the concept of contract rigidity, why managers have an interest in accounting policy choice. Section 9.5 demonstrates why debt contracts typically contain covenants to protect lenders. Such covenants were largely taken for granted in Chapter 8. For those who wish to delve deeper, the Section 9.3 illustrates and discusses concepts of biased reporting and earnings management. My objective in introducing this material is to better integrate the theory into the coverage of executive compensation and earnings management in Chapters 10 and 11. In particular, I show in Examples 9.4 and 9.5 that uncontrolled earnings management results in a very inefficient contract. However, Example 9.6 shows that that if it is controlled (but not eliminated) by GAAP, earnings management can be “good,” in the sense that a contract that allows a degree of earnings management can be more efficient than one that motivates the manager to tell the truth. This leads into the discussion of good versus bad earnings management in Chapter 11. However, Chapter 11 stands on its own and does not require much of the material in this chapter. Since most students will not have been exposed to agency theory before, I suggest working through some of the examples in class, or distributing solutions to end-ofchapter problems and ask the students to work the problems on their own. My main 322 .

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goal is that the students understand why compensating a manager based on some measure of his/her performance is usually desirable when moral hazard is present, and are aware of the properties that net income needs to control moral hazard efficiently. The risk-sharing aspect of agency contracts is worth emphasizing. The main point is that to motivate effort, the manager must bear compensation risk—a fixed salary does not provide any effort incentive. Instructors may wish to challenge this point, however. What about ethics? Should an ethical manager shirk on his/her employer? I counter this argument by asking what would happen if I cancelled the final exam. What about reputation? While perhaps not completely convincing, I counter this argument by suggesting that managers may be able to disguise shirking and preserve their reputations by earnings management. Nevertheless, the reason I suggest discussion of risk-sharing is that it supports the point made several times in the book that new accounting standards that increase the volatility of earnings will be objected to by managers. Since the manager is assumed risk averse, increased compensation risk lowers the manager’s expected utility. Appreciation of the manager’s legitimate concern about risk helps students to understand the controversies surrounding many accounting standards. I use the discussion of Holmström’s well-known 1979 paper in Section 9.6.1 to develop several implications of agency theory for accounting: •

Is net income sufficiently observable that it can serve as a basis for manager compensation? GAAP and the audit are the vehicles that give net income sufficient observability that parties are willing to use it in contracts. Although financial reporting disasters such as Enron may threaten this argument, a theme of this book is that the contracting role for net income is equally as important as its role in informing investors. •

I suggest to the class that historical cost-based net income, or at least net income which excludes or minimizes current cost based valuations, may be more informative about manager effort (and hence a more efficient performance measure on which to base manager compensation) than net 323 .

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income determined under a fair value-based measurement perspective, the reason being that current cost introduces low precision, which may outweigh its greater sensitivity. A related argument is that net income based on contract theory, emphasizing reliability and conditional conservatism, is more precise but less sensitive than fair value accounting—a different trade-off. These arguments could be discussed in the context of amortized cost accounting for financial assets held to receive interest and principle under IFRS 9 versus fair value accounting for these assets. •

Holmström’s main contribution in his 1979 paper was his informativeness condition, that is, the condition under which basing the agent’s compensation on a second variable, in addition to the payoff itself, would increase contracting efficiency. This leads to a suggestion to base managerial compensation on both net income and share price.

•

It is important to point out the rigid nature of contracts, once they are signed, and to discuss the reasons for rigidity. Otherwise, students tend to ask what the fuss is all about when GAAP changes. Why not just amend the contract when this happens? Contract rigidity is crucial for accounting policies to have economic consequences. The Mosaic, CanWest Group, and AbitibiBowater examples in Theory in Practice 9.2 are useful in bringing out the consequences of rigidity, and convincing students that the implications of contracts (debt covenants in this case) for accounting matter.

To Motivate Agency Theory to Accountants

Since the theory may be new to many students, I work to convince them it is relevant to their future careers. Some of the points I bring out are; •

Agency relationships are very common. I sometimes discuss examples such as hockey players, and ask why they are motivated to work hard. Presumably their 324 .

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effort is observable, so that they receive primarily salaries. I also ask about visiting a lawyer or doctor, and ask how one can be sure the professional will work hard on the client’s behalf. Here, the outcome is observable but the effort is not. Asking what motivates an auditor to work hard also draws interesting replies. The point here is that agent effort is important to everyone, and the extent to which effort is observable influences how the agent is motivated and compensated in predictable ways. •

I suggest to the students that in their careers they will find that much attention is given to accounting policy choice and they will be arguing with managers about such choices. Indeed, some of them will eventually be managers. Agency theory helps us to understand how managers view accounting policies. For example, the fact that managers bear considerable risk helps explain their often-negative reaction to new accounting policies, especially ones that increase income volatility,, such as fair value.

•

I use Holström’s informativeness condition to point out that accounting competes with share price as a performance measure. The demand for accountants’ services will fall if net income is squeezed out of compensation and debt contracts. Students should be aware of the properties a good performance measure should have, (the best trade-off between sensitivity and precision) and that these properties are not necessarily the same as those needed to inform investors (best trade-off between relevance and reliability).

To Reconcile Economic Consequences with Efficient Securities Markets

Finally, I use the prediction from agency theory that important classes of contracts will be based on accounting variables, in conjunction with contract rigidity, to emphasize the argument in the text that accounting policies can have economic consequences even if securities markets are efficient. By this time, students have no problem in accepting this argument (or else I have worn them out). I should note, however, that I back off this argument somewhat in Section 11.6.2, by suggesting that another reason for economic consequences arises if managers do not accept securities market efficiency. Then, they 325 .

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may feel they can influence the securities market by accounting policy choice and will object if accountants try to constrain those choices.

326 .

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

The manager’s effort is usually unobservable to owners because of the complex and broadly-defined nature of manager effort. As a result, when the owner and manager are different persons or unless the firm is very small, it is effectively impossible for a firm owner or shareholder to observe whether the manager is working hard or shirking. If the manager receives a straight salary, his/her compensation does not depend on the amount of effort exerted. Since managers are assumed to be rational and effort-averse in agency theory, their utility will be maximized by working as little as possible, in a single period contract. An alternate answer is to point out that if the manager receives a straight salary, he/she bears no compensation risk. Compensation risk is necessary if hard work is to be motivated.

The payoffs from current manager effort often take a long time. Sales on credit are a common example, since cash collection may not take place until next period. As another example, payoffs from current R&D are usually not known until after the current period is ended. Also, the ultimate payoffs from current purchases of financial instruments are often unknown until a subsequent period. Furthermore, negative payoffs, such as environmental liabilities that may result from current manager effort, and cash payments needed to pay off financial instruments issued currently, are often unknown at the end of the current period. Compensation contracts respond to the need to pay the manager currently by basing compensation on performance measures, such as net income and/or share price, that anticipate future cash flows. When measuring net income, accountants use accruals to anticipate future cash flow payoffs. For example, provisions for doubtful accounts anticipate future cash losses from accounts receivable. Payoffs are also anticipated by fair value accounting since, if markets 327 .

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work well, current market value is the best estimate of future payoffs (see Section 7.2.2). In other cases, due to reliability problems, payoffs from current effort are not anticipated at all (i.e., recognition lag), as in the accounting for R&D and many environmental liabilities. To compensate, contracts often base compensation on share price performance in addition to net income, since the securities market will anticipate future payoffs due to current R&D and environmental liabilities. 3.

Less noise means greater precision of net income as a performance measure. Greater precision means greater accuracy in measuring the ultimate payoff. This reduces the manager’s compensation risk. When net income is unbiased, there is no effect on sensitivity. The result is a more efficient contract. When net income is unbiased, accountants can reduce noise in net income by more accurate (i.e., less noisy) estimates of fair values, hence of future payoffs. Yes, the argument changes. If net income is a biased payoff predictor, greater precision could possibly be outweighed by lower sensitivity of net income. For example, a move from historical cost (i.e., biased net income) to fair value will increase sensitivity due to lower recognition lag, but precision will likely decrease. Unless there is a well-working market for the fair-valued assets and liabilities, fair values are subject to error and possible manager bias, reducing precision.

The basic reason for debt covenants is the moral hazard problem between manager and lender. As a result, lenders demand a high interest rate to protect themselves from the expected opportunistic manager behaviour (e.g., excessive dividends or additional borrowing). To lower the interest rate demanded, the manager may commit not to engage in this behaviour. Debt covenants based on accounting variables are a commitment device, which increase investor trust that the manager will not act opportunistically against their interests.

328 .

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However, debt covenants are not completely credible. Credibility is increased to the extent that GAAP and auditing prevent the manager from excessive earnings management. However, the manager still has considerable room to manage earnings opportunistically within GAAP. Note: See Theory in Practice 7.3 re Lehman Brothers for an example of opportunistic manager action within (?) GAAP. 5.

Current net income is not fully informative about manager effort because the full payoff from current manager effort is not realized until some time in the future. While net income contains accruals to estimate these future payoffs, these accruals are often subject to error and possible manager bias. Also, net income is subject to recognition lag, such as for R&D, where the possibility of error and manager bias is so great that future cash flows are not accrued at all. Note: An alternate answer is that net income is not completely precise and sensitive. Even if net income is unbiased, noise reduces effort informativeness. If net income is a biased payoff predictor, further reductions in effort informativeness are possible due to recognition lags and possible manager opportunism.

Sensitivity is the rate at which the expected value of a performance measure increases as the manager works harder, or decreases as the manager shirks. Precision is the ability of a performance measure to accurately predict the payoff. It is measured as the reciprocal of the variance of the noise in the performance measure. When a performance measure is precise, it is unlikely that it will differ substantially from the payoff. Accountants can increase sensitivity by adopting fair value accounting, under which unrealized gains as well as unrealized losses are recognized. This increases sensitivity because fair value accounting captures more of the results of current manager effort than mixed measurement model accounting, where

329 .

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some assets and liabilities are not valued at all (e.g., R&D) or valued at historical cost. While many assets are subject to impairment tests, as recommended, for example, by contract theory (conditional conservatism), fair value accounting also increases sensitivity relative to contract theory accounting, since unrealized increases in value are recognized as well as decreases. Accountants can increase precision by reverting to historical cost accounting, thereby reducing the effects of economy-wide events and also reducing the possibility of error and bias in fair value estimates. Precision would also be increased, but less than under historical cost, by adopting contract theory accounting. Under which the potential for low precision is reduced by not recognizing unrealized gains. Yet another way to increase precision relative to historical cost is to adopt amortized cost accounting (i.e., value-in-use), such as for financial instruments held to generate interest and principle payments under IFRS 9. Here, precision is increased by discounting future expected receipts at the interest rate established at acquisition, not by more volatile current interest rates. The estimated amounts and timing of future receipts are still subject to error or possible bias, however. These two qualities have to be traded off when net income is a biased predictor of the payoff, since then an increase in sensitivity usually (i.e., unless fair value is determined on a well working market) requires more estimates and is more subject to manager bias, both of which reduce precision. When accounting is unbiased, increases in precision do not affect sensitivity since sensitivity changes at the same rate as the payoff. That is, sensitivity then captures all relevant aspects of manager effort. 7.

This $25 net income could happen if some state of nature that was not anticipated was realized during the year. This could happen, for example, if a new accounting standard changes the way net income is calculated. 330 .

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Alternatively, any other unanticipated event, such as a new competitor entering the industry, could reduce profits. A contract that does not anticipate all possible state realizations is incomplete. Possible manager reactions: •

Ask to renegotiate the contract. This may be difficult, however, due to contract rigidity.

•

Manage earnings upward to restore compensation to anticipated amount and minimize ant effects on debt covenants.

•

If a new accounting standard is the reason, intervene in the standardsetting process, to try to secure reversal or modification of the new standard.

331 .

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This is a version of the “owner rents firm to the manager” or tenant farming scenario described in Section 9.2.2. Here, we can think of a firm as the principal, or employer, with the employee as the agent or manager. The employer pays a fixed rental to the employee for the move. The employee is then motivated to move as cheaply as possible, since he/she keeps any excess. Note that since a fixed amount is paid by the company, the employee also bears the risk of loss or damage during the move. Thus, the employee does all the work and bears all the risk. This also illustrates how the employee’s decision about how much effort to exert in moving is internalized. By paying a fixed allowance, the employer does not care how hard the employee works on the move. This is internalized to the employee. Under the previous arrangement, the employer did care how hard the employee worked on the move. The harder the employee worked, the lower the moving costs paid to the moving company. However, with the employer paying the moving costs, an effort-averse employee would obviously prefer to exert no effort (a moral hazard problem), let the moving company do all the work and bear all the risk, and send the bill to the employer. U-Haul’s offer to reimburse for oil follows from the fact that, since the employee does not own the moving truck, he/she has no incentive to look after it (another moral hazard problem). By offering to pay for oil, U-Haul reduces the incentive for the employee to shirk on his/her obligation to keep the oil level up. This offer does not apply to gasoline since the truck will not move without gas.

Denote working hard by a1 and shirking by a2. Yvonne’s expected utility of

each act is: EUm(a1 ) = 0.9 × (100 + .10 × 2,000)1/2 + 0.1 × (100 + .10 × 900)1/2 – 4 = 0.9 × (300)1/2 + 0.1 × (190)1/2 – 4 = 0.9 × 17.32 + 0.1 × 13.78 – 4 = 15.59 + 1.38 – 4 332 .

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= 12.97

EUm(a2 ) = 0.1 × 17.32 + 0.9 × 13.78 – 1.1 = 1.73 + 12.40 – 1.1 = 13.03

Yvonne accepts because her expected utility is greater than her reservation utility of 11. She will shirk.

Under the new contract, Yvonne’s expected utility of each act is:

EUm(a1) = 0.9 × (52.30 + .0921 × 2,000)1/2 + 0.1 (52.30 + .0921 × 900)1/2 – 4 = 0.9 × (236.50)1/2 + 0.1 × (135.19)1/2 – 4 = 0.9 × 15.38 + 0.1 × 11.63 – 4 = 13.84 + 1.16 – 4 = 11

EUm(a2) = 0.1 × 15.38 + 0.9 × 11.63 – 1.1 = 1.54 + 10.47 – 1.1 = 10.91

Yvonne hesitates because her expected utility is lower than under the original contract. However, since she can attain her reservation utility she does accept. She will work hard.

Denote Pierre’s utility by EUO: EUO (original contract) = 0.1 × (2,000 – 100 - 200) + 0.9 × (900 - 100 - 90) = 0.1 × 1700 + 0.9 × 710 = 170 + 639 = 809 333 .

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EUO (new contract) = 0.9 × (2,000 - 52.30 - 184.20) + 0.1 × (900 - 52.30 - 82.89) = 0.9 × 1763.50 + 0.1 × 764.81 = 1587.15 + 76.48 = 1663.63

The new contract yields Pierre higher expected utility. The new contract is thus more efficient. This is both because it now motivates Yvonne to work hard, and because it gives her reservation utility. The old contract motivated shirking and gave her more than her reservation utility. 10.

The payoff table for Growth Ltd. is as follows: Manager’s Act a1 (work hard)

a2 (shirk)

Net Inc.

Probability

Net Inc.

Probability

High net income

$500

0 .7

$500

0.2

Low net income

$200

0.3

$200

0.8

The manager’s expected utility for each act is: EU(a1) = 0.7 41 + .2 × 500 + 0.3 41 + .2 × 200 - 2 = 0 .7 × 11.87 + 0 .3 × 9 - 2 = 8.31 + 2.70 - 2 = 9.01 334 .

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EU(a2) = 0.2 × 11.87 + 0.8 × 9 - 0 = 2.37 + 7.20 = 9.57 The manager will take a2. EU(a1) = 0.7 0.3 × 500 + 0 .3 0.3 × 200 - 2

= 0.7 × 12.25 + 0.3 × 7.75 - 2 =

8.58 + 2.32 - 2

8.90

EU(a2) = 0.2 × 12.25 + 0.8 × 7.75 - 0 = 2.45 + 6.20 = 8.65 The manager will now take a1. Note: It is assumed in parts a and b that the prospective manager’s reservation utility is met. c.

Yes. The elimination of salary plus higher profit percentage in b provides

sufficiently more expected utility of compensation that it overcomes the disutility of working hard. Alternatively, the contract in b imposes more risk on the manager. This motivates her to work harder. d.

An advantage of using two performance measures was demonstrated by

Holmström (1979). A second measure increases contracting efficiency provided that the second measure tells us something about the manager’s effort beyond 335 .

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the first measure. This would seem to be the case for share price since, despite its volatility (i.e., lower precision), share price on an efficient market reflects all publicly available information about the firm (higher sensitivity). That is, share price draws on a larger set of information than net income, which does not include items such as effort devoted to R&D, capital investment, some unrealized gains, plans for mergers, growth expectations, environmental liabilities, and prospective lawsuits. 11.

Let the proportion of net income be x. Then we want

EU m (a1 ) = 0.75 725 x + 0.25 0 − 2 = 6 = 0.75 × 26.93 x + 0 − 2 = 6 = 20.20 x = 8 from which 8 x= = .40 20.20 x = .16 b.

To check, this profit share yields EU m (a1 ) = 0.75 .16 × 725 − 2 = 0.75 116 − 2 = 0.75 × 10.77 − 2 = 8.08 − 2 ≈6

If Lily shirks with this profit share, her expected utility is EU m (a 2 ) = 0.20 .16 × 725 + 0.80 0 − 1

= 0.20 116 − 1 = 0.20 × 10.77 − 1 = 2.15 − 1 = 1.15

Consequently, Lily will work hard. 336 .

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If Lily manages earnings and shirks in year 1, net income of $725 is

reported regardless of unmanaged net income. Lily’s expected utility is EU m (a 2 ) = .16 × 725 − 1 = 116 − 1 = 10.77 − 1 = 9.77

If she does not manage earnings, and works hard, her expected utility, from b is 6. Thus Lily would be better off in year 1 to manage earnings and shirk.

Suppose that unmanaged net income is $725. Then, if Lily reports

truthfully, that is $725 net income, the compensation she needs to attain reservation utility, given that she shirks, is given by: EU m (a 2 ) = 725 x − 1 = 6 x=

725 x = .0676

7 = .2600 26.9258

If net income is truthfully reported as zero, Lily must receive a salary to attain reservation utility. The required salary s is: EU m (a 2 ) = s − 1 = 6 s =7 s = 49

Thus a contract which pays .0676 of net income if reported as $725 and a salary of $49 if net income is reported as 0 motivates truthful reporting. In each case, 337 .

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Lily receives her reservation utility of 6. Consequently, although she will shirk, she has no motivation to manage net income.

Note: A contract that simply pays Lily a salary of $49 regardless of unmanaged net income has the same effect. Either contract is acceptable.

If Lily works hard, the required proportion of net income to attain

reservation utility of 6 is:

EU m (a1 ) = 0.75 784 x + 0.25 9 x − 2 = 6 = 0.75 × 28 x + 0.25 × 3 x = 8 = (21 + .75) x = 8 8 = .3678 x= 21.75 x = .1353

If Lily shirks under this contract, her expected utility is: EU m (a 2 ) = 0.20 .1353 × 784 + 0.80 .1353 × 9 − 1 = 0.20 106.0752 + 0.80 1.2177 − 1 = 0.20 × 10.2993 + 0.80 × 1.1035 − 1 = 2.0598 + .8829 − 1 = 2.9426 − 1 = 1.9426

Since this is less than reservation utility, Lily will now work hard, and will manage earnings within GAAP.

12.

Yuan will shirk, because she receives her salary in either case, but incurs

a lower disutility of effort if she shirks.

Note: Calculations are not required. However, they are: 338 .

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EUm(a1) = 0.6×√64 + 0.4×√64 – 2 = 4.8 + 3.2 – 2 = 6 EUm(a2) = 0.3×√64 + 0.7×√64 -1 = 7 b.

You advise against a salary because you know that, with a fixed salary

that yields more than reservation utility, Yuan will accept and shirk in a one-year contract.

Let the proportion of net income be x. Then we want

EU m (a1 ) = 0.6 1600 x + 0.4 400 x ) − 2 = 6 = 0.6 × 40 x + 0.4 × 20 x − 2 = 6 = 24 x + 8 x = 8 from which 8 = .25 32 x = .0625 x=

You recommend a .0625 share of net income (before manager compensation).

Note: In Part d it is verified that Yuan will work hard if offered this profit share.

Feng’s expected utility if Yuan is paid a salary (Yuan will shirk):

EUo = 0.3 × (1,600 – 64) + 0.7 × (400 - 64) = 0.3 × 1,536 + 0.7 × 336 = 460.80 + 235.20 = 696

Feng’s expected utility if Yuan paid .0625 of net income:

EUo = 0.6 × (1,600 - .0625 × 1,600) + 0.4 × (400 - .0625 × 400) 339 .

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= 0.6 × (1,600 – 100) + 0.4 × (400 – 25) = 0.6 × 1,500 + 0.4 × 375 = 900 + 150 = 1,050 Feng’s expected utility is higher under the .0625 of net income contract. This is because Yuan will work hard under this contract. d.

Your recommended profit share of .0625 yields Yuan:

EU m (a1 ) = 0.6 .0625 × 1600 + 0.4 .0625 × 400 − 2 = 0.6 100 − 0.4 25 − 2 = 0.6 × 10 + 0.4 × 5 − 2 = 6+2−2 =6

If Yuan shirks with this profit share, her expected utility is EU m (a 2 ) = 0.3 .0625 × 1600 + 0.7 .0625 × 400 − 1 = 0.3 100 + 0.7 25 − 1 = 3 + 3.5 − 1 = 6.5 − 1 = 5.5

Consequently, Yuan will work hard.

13.

We want

EU m (a1 ) = 0.7 10,000 x + 0.3 1,600 x − 2 = 12 = 0.7 × 100 x + 0.3 × 40 x − 2 = 12 = 70 x + 12 x = 14 from which 14 = .1707 x= 82 x = .0291 You recommend a .0291 share of net income (before manager compensation). 340 .

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Your recommended profit share of .0291 yields Henry: EU m (a1 ) = 0.7 .0291 × 10,000 + 0.3 .0291 × 1,600 − 2

= 0.7 291 − 0.3 46.56 − 2 = 0.7 × 17.0587 + 0.3 × 6.8235 − 2 = 11.9411 + 2.0471 − 2 = 11.9882 ≈ 12 Note: Difference due to rounding. If Henry shirks with this profit share, his expected utility is EU m (a 2 ) = 0.3 .0291 × 10,000 + 0.7 .0291 × 1,600 − 1 = 0.3 291 + 0.7 46.56 − 1 = 0.3 × 17.0587 + 0.7 × 6.8235 − 1 = 5.1176 + 4.7764 − 1 = 9.8940 − 1 = 8.8940

Consequently, since this is less than EUm(a1) (and less than reservation utility of 12), Henry will work hard. Note: Calculations for EUm(a1) need not be shown since we know from part a that EUm(a1) = 12 c.

To compare sensitivities:

Sensitivity is the increase in the expected value of the performance measure as the manager works harder. Expected net income under mixed measurement Manager works hard: EV(NI) = 0.7 × 10,000 + 0.3 × 1,600 = 7,000 + 480 = 7,480 Manager shirks: EV(NI) = 0.3 × 10,000 + 0.7 × 1,600 = 3,000 + 1,120 = 4120 Increase in expected value of net income as manager works harder: 341 .

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7,480 – 4,120 = $3,360

Expected net income under fair value: Manager works hard: EV(NI) = 0.7 × 11,025 + 0.3 × 900 = 7,717.50 + 270 = 7,987.50 Manager shirks: EV(NI) = 0.3 × 11,025 + 0.7 × 900 = 3,307.50+ 630 = 3,937.50 Increase in expected value of net income as manager works harder:

7,987.50 – 3,937.50 = $4,050

Since the increase in expected value of net income as the manager works harder under fair value exceeds the increase under mixed measurement, the sensitivity of fair value accounting (in this example) exceeds that under mixed measurement.

To compare precisions: Precision is the reciprocal of the variance of the performance measure. Note: Since the manager works hard, we compare only the variances of net income assuming manager works hard. Comparing variance of net income under shirking yields a similar conclusion.

Variance of net income under mixed measurement: Var(NI) given manager works hard: 0.7(10,000 – 7,480)2 + 0.3(1,600 – 7,480)2 = 0.7(2,520)2 + 0.3(-5,880)2 = 0.7 × 6,350,400 + 0.3 × 34,574,400 = 4,445,280 + 10,372,320 = 14,817,600

342 .

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Reciprocal = 6.75

Variance of net income under fair value: Var(NI) given manager works hard: 0.7(11,025 – 7,987.50)2 + 0.3(900 – 7,987.50)2 = 0.7(3,037.50)2 + 0.3(-7,087.50)2 = 0.7 × 9,226,406.25 + 0.3 × 50,232,656.25 = 6,458,484.375 + 15,069,796.875 = 21,528,281.25

Reciprocal = 4.65

Since the precision of net income under fair value is less than the precision of net income under mixed measurement, fair value (in this example) is less precise than mixed measurement.

The fair value contract is more efficient than under mixed measurement, since a lower net income share is needed to motivate Henry to work hard. The reason it is more efficient is that the increased manager effort motivation from the increase in sensitivity of the fair value contract must outweigh the greater manager risk resulting from its lower precision.

14.

The (net of amount loaned) payoff table is: State

Payoff

θ1

$40.00

θ2

0.00

θ3

-500.00

Expected payoff is 0.80 × 40 + 0.18 × 0 + 0.02 × -500 343 .

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= 32 - 10. = $22.00 Expected rate of return is thus 22/500 = 4.4% Since this is less than 6%, Mr. K should not make the loan. Note: Expressing payoffs gross of amount loaned yields similar conclusion. b.

If coverage ratio falls below 4, expected payoff is: 0.95 × 40 + 0.04 × 0 + 0.01 × -500 = 38 - 5 = $33.

If coverage ratio does not fall below 4, expected payoff is: 0.87 × 40 + 0.12 × 0 + 0.01 × -500 = 34.8 - 5 = $29.8 Since the probability of the coverage ratio falling below 4 is 0.60, the unconditional expected rate of return is: (0.6 × 33 + 0.4 × 29.8)/500 = (19.8 + 11.92)/500 = 31.72/500 = 0.06344 Since this is greater than 6%, Mr. K should make the loan.

344 .

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The payoff table is: a1 (8% interest)

a2 (5% interest)

Payoff

Probability

Payoff

Probability

Bankrupt

8,000

0.25

8,000

0.01

Not Bankrupt

10,800

0.75

10,500

0.99

Calculate the expected utility of each act: 𝐸𝑈(𝑎1 ) = 0.25�8,000 + 0.75�10,800

= 0.25 × 89.427 + 0.75 × 103.9230 = 22.3607 + 77.9423 = 100.3030

𝐸𝑈(𝑎2 ) = 0.01√8,000 + 0.99�10,500

= 0.01 × 89.4427 + 0.99 × 102.4695 = .8944 + 101.4448 = 102.3392

Toni should take a2. b.

It appears that the contract is incomplete, that is, no procedures are laid

down in the contract to deal with the effects of a change in GAAP on the covenant ratio. Therefore, due to contract rigidity, it will be hard to change the contract if GAAP changes. A change in GAAP that lowers reported net income and/or increases its volatility will then be of concern to the manager because the probability of violation of 345 .

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covenant ratios will increase. This will impose costs on the firm and its manager, due both to the increased probability of costs from debt covenant violation and reduced compensation if the manager’s compensation depends on reported net income and/or share price. Share price on an efficient market will be reduced if the market assesses an increased probability of debt covenant violation.

16.

Let the required profit share be k.

EU m (a1 ) = 0.8[0.7 625k + 0.3 225k ] + 0.2[0.3 625k + 0.7 225k ] − 8 = 2.6 = 0.8[0.7 × 25 k + 0.3 × 15 k ] + 0.2[0.3 × 25 k + 0.7 × 15 k ] − 8 = 2.6 = 0.8[17.5 k + 4.5 k ] + 0.2[7.5 k + 10.5 k ] − 8 = 2.6 = 0.8 × 22 k + 0.2 × 18 k − 8 = 2.6 = 17.6 k + 3.6 k − 8 = 2.6 = 21.2 k = 10.6 k = 10.6 / 21.2 = .5 k = .25

Arnold offers Minnie 25% of net income. To verify that Minnie will work hard:

EU m (a 2 ) = 0.2[0.7 625 × .25 + 0.3 225 × .25 ] + 0.8[0.3 625 × .25 + 0.7 225 × .25 ] − 7 = 0.2[0.7 156.25 + 0.3 56.25 ] + 0.8[0.3 × 156.25 + 0.7 × 56.25] − 7 = 0.2[0.7 × 12.5 + 0.3 × 7.5] + 0.8[0.3 × 12.5 + 0.7 × 7.5] − 7 = 0.2[8.75 + 2.25] + 0.8[3.75 + 5.25] − 7 = 0.2 × 11 + 0.8 × 9 − 7 = 2.2 + 7.2 − 7 = 2.4 Minnie will work hard since her expected utility is 2.6 > 2.4. b.

Arnold specified that net income be audited to reduce the possibility that Minnie would shirk and cover up by managing earnings.

346 .

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This is a case of moving support since if net income of $400 is observed, Arnold will know that Minnie has shirked. Arnold will offer Minnie a fixed salary of s = $112.36 unless net income is $400, in which case she would receive a salary of $84.09 or less. To verify:

If Minnie works hard, net income cannot be $400. Minnie receives a salary of $s sufficient to attain reservation utility, regardless of the amount of net income. EU m (a1 ) = s − 8 = 2.6 s = 10.6 s = $112.36

If Minnie shirks, she receives her full salary with probability 0.3 and salary of $x with probability 0.7 EU m (a 2 ) = 0.3 112.36 + 0.7 x − 7 = 2.6 = 0.3 × 10.6 + 0.7 x − 7 = 2.6 = 3.18 + 0.7 x = 9.60 x = 6.42 / 0.7 = 9.17 x = 84.09 where x is the salary that would make Minnie indifferent between working hard and shirking. Minnie receives reservation utility of 2.6 regardless of whether she works hard or shirks. If so, the theory assumes that she will work hard. Note: For consistency with the text, paying a salary of $84.09 if net income of $400 is observed is equivalent to penalizing the manager by 112.36 – 84.09 = $28.27. Note: Calculation of the 2 salaries not needed if the answer specifies that Arnold would offer a fixed salary sufficient to give Minnie her reservation utility if she works hard, and, if she shirks and net income of $400 is observed, a lower salary such that her expected utility is equal or less than her reservation utility. 347 .

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The manager’s expected utility for a1 is:

[ ] [ = 0.6[0.8462 35.0350 + 0.1538 14.3325 ] + 0.4[0.1538 35.0350 + 0.8462 14.3325 ] − 2

]

EU (a1 ) = 0.6 0.8462 .3185 × 110 + 0.1538 .3185 × 45 + 0.4 0.1538 .3185 × 110 + 0.8462 .3185 × 45 − 2 = 0.6 × 5.5910 + 0.4 × 4.1138 − 2 = 3.3546 + 1.6455 − 2 = 3.0001 = 3.00 approx. Expected utility for a2 is:

EU (a 2 ) = 0.4 × 5.5910 + 0.6 × 4.1138 − 1.71 = 2.2364 + 2.4683 − 1.71 = 2.9947 The manager will work hard (a1) and receive reservation utility of 3. The contract of Example 9.3 is more efficient than the contract of Example 9.2 because the manager attains reservation utility with a lower profit share. Alternatively, the manager bears less compensation risk due to the lower volatility of net income. This greater efficiency is evidenced by an increase in the owner’s expected utility from 55.4566 in Example 9.2 to 55.8829 in Example 9.3. The agency cost is reduced to 1.1171 from 1.5434. Accountants can increase contracting efficiency when net income is unbiased by reducing the noise in net income, that is, by improving the precision of net income in predicting the payoff. This can be accomplished by improved (i.e., more precise) measurement. Note: Answers are improved by giving an example, such as better estimates of environmental liabilities and of the fair value of R&D.

18.

A manager may not manage earnings, despite the temptation to do so, because 348 .

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•

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The owner may hire an auditor. If so, the earnings management may be revealed.

•

Accruals reverse. This will make it more difficult to manage earnings in future years, should the contract be renewed.

•

The manager may be concerned about damage to reputation if opportunistic earnings management is discovered. This would lower reservation utility.

•

Ethical considerations.

Note: Two additional reasons can be suggested from material covered in Chapter 10 (Section 10.2): •

Internal monitoring. Subordinates, who want the manager’s job, may whistle-blow (Fama, (1980)).

•

Co-workers may threaten to shirk next period if the manager shirks this period (Arya, Fellingham and Glover (1997)).

19.

Let the percentage of net income be k. Then:

349 .

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EU m (a1 ) = 0.7[0.8 725k + 0.2 100k ] + 0.3[0.16 725k + 0.84 100k ] − 2 = 5 = 0.7[0.8 × 26.93 + 0.2 × 10]k 1 / 2 + 0.3[0.16 × 26.93 + 0.84 × 10]k 1 / 2 = 7 = 0.7[21.54 + 2]k 1 / 2 + 0.3[4.31 + 8.40]k 1 / 2 = 7 = [0.7 × 23.54 + 0.3 × 12.71]k 1 / 2 = 7 = (16.48 + 3.81)k 1 / 2 = 7 7 = .34 20.29 = k = .12 = k 1/ 2 =

Thus you recommend compensation of .12 times net income. b.

You require net income to be audited to reduce the likelihood of

opportunistic earnings management. The auditor will ensure that GAAP is followed. c.

EU m (a1 ) = 0.7[0.8 .12 × 725 + 0.2 .12 × 100 ] + 0.3[0.16 .12 × 725 + 0.84 .12 × 100 ] − 2 = 0.7[0.8 87 + 0.2 12 ] + 0.3[0.16 87 + 0.84 12 ] − 2 = 0.7[0.8 × 9.33 + 0.2 × 3.46] + 0.3[0.16 × 9.33 + 0.84 × 3.46] − 2 = 0.7[7.46 + .69] + 0.3[1.49 + 2.91] − 2 = 0.7 × 8.15 + 0.3 × 4.40 − 2 = 5.71 + 1.32 − 2 = 5.03 ≈ 5.00, difference due to rounding EU m (a 2 ) = 0.3 × 8.15 + 0.7 × 4.40 − 1 = 2.45 + 3.08 − 1 = 4.53 Thus the manager will take a1 and work hard. d.

The percentage of net income will now be lower. This is because net

income falls within a narrower range of the payoff. That is, net income, while still unbiased, is less noisy. It does a more precise job of predicting the cash flow resulting from the manager’s effort. This means that the manager bears less compensation risk. 350 .

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Consequently, she can attain her reservation utility with a lower share of net income.

20.

First, calculate the expected value of reported net income under each effort

alternative: If manager shirks, expected reported net income is: 0.4(0.8 × 116 + 0.2 × 41) + 0.6(0.2 × 116 + 0.8 × 41) = 0.4 × 101 + 0.6 × 56 = 40.4 + 33.6 = 74 If manager works hard, expected reported net income is: 0.6 × 101 + 0.4 × 56 = 60.6 + 22.4 = 83 The percentage increase in reported net income (i.e., sensitivity) is thus: 9/74 × 100 = 12.16%

To calculate precision given work hard, first calculate the variance of reported net income, given a1: NI

Prob. NI/a1

Calculation of Variance

116

0.56

(116 – 83)2 × 0.56 = 1,089 × 0.56 = 609.84

0.44

(41 – 83)2 × 0.44 = 1,764 × 0.44 = 776.16 1,386.00

Precision is thus 1/1,386 = .0007 351 .

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Note: Given that the manager works hard, net income of $116 will be reported with probability 0.8 if payoff is going to be high (prob. = 0.6) and with probability 0.2 if payoff is going to be low (prob. = 0.4)—see Example 9.6. Thus probability net income = 116 calculated as 0.6 × 0.8 + 0.4 × 0.2 = 0.48 + 0.08 = 0.56

21.

If the manager works hard, his expected utility is:

EU m (a1 ) = 0.6(0.7 300k + 0.3 50k ) + 0.4(0.2 300k + 0.8 50k ) − 2.5 = [0.6(0.7 × 17.32 + 0.3 × 7.07) + 0.4(0.2 × 17.32 + 0.8 × 7.07)]k 1 / 2 − 2.5 = [0.6(12.12 + 2.12) + 0.4(3.46 + 5.66)]k 1 / 2 − 2.5 = k 1 / 2 [(0.6 × 14.24) + (0.4 × 9.12)] − 2.5 = k 1 / 2 (8.54 + 3.65) − 2.5 = k 1 / 2 × 12.19 − 2.5

where k is the manager’s share of net income. If the manager is to accept the contract, his expected utility must equal 4: k 1 / 2 × 12.19 − 2.5 = 4 k 1 / 2 = 6.5 / 12.19 = 0.53 k = 0.28 Thus the manager’s profit share is 28%. To verify that the manager will work hard, calculate his expected utility if he shirks:

352 .

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EU m (a 2 ) = 0.2(0.7 300 × .28 + 0.3 50 × .28 ) + 0.8(0.2 300 × .28 + 0.8 50 × .28 ) − 1.8 = 0.2(0.7 84 + 0.3 × 14 ) + 0.8(0.2 84 + 0.8 14 ) − 1.8 = 0.2(0.7 × 9.17 + 0.3 × 3.74) + 0.8(0.2 × 9.17 + 0.8 × 3.74) − 1.8 = 0.2(6.42 + 1.12) + 0.8(1.83 + 2.99) − 1.8 = 0.2 × 7.54 + 0.8 × 4.82 − 1.8 = 1.51 + 3.86 − 1.8 = 3.57 Since this is less than EUm(a1) of 4, the manager will work hard. b.

This is a case of moving support. If the owner observes net income of

$30, she will know that the manager chose a2. Consequently, a contract paying a straight salary, subject to a sufficient penalty if net income is $30, is first-best. To determine the penalty, first determine the required salary s which the manager will receive for sure if he works hard:

EU m (a1 ) = s 1 / 2 − 2.5 = 4 s 1 / 2 = 6.5 s = 42.25

Thus $42.25 is the required salary, yielding the manager his reservation utility of 4. Then, the manager will be indifferent between working hard or shirking if 0.3√42.25 + 0.7√𝑘 − 1.8 = 4

0.3 × 6.5 + 0.7√𝑘 − 1.8 = 4 1.95 + 0.7√𝑘 = 5.8 √𝑘 =

3.85 = 5.5 0.7

k = 30.25 353 .

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In sum, you would recommend a contract giving the manager a salary of $42.25 unless net income of $30 is observed, in which case the salary is $30.25 or less. Equivalently, pay the manager a salary of $42.25, with a penalty of $42.25 – $30.25 = $12 or more if net income of $30 is observed. c.

The agency cost of the contract in a. is the difference between the

owner’s expected utility under the first-best contract of part b and her expected utility under part a. The owner’s expected utility equals the payoff, less compensation to the manager. Also, the owner knows that the manager will take a1. EU O (a1 , firstbest ) = 0.6(225 − 42.25) + 0.4(100 − 42.25) = 0.6 × 182.75 + 0.4 × 57.75 = 109.65 + 23.10 = 132.75 Under the contract in a., the manager receives 28% of net income. The owner’s expected utility is

EU O (a1 , contract in a ) = 0.6(225 − 225 × .28) + 0.4(100 − 100 × .28) = 0.6(225 − 63) + 0.4(100 − 28) = 0.6 × 162 + 0.4 × 72 = 97.20 + 28.80 = 126 Note: In this calculation, use is made of the fact that net income is here an unbiased estimate of the payoff. The agency cost of the contract in part a is thus 132.75 – 126 = 6.75. 22.

The finding that earnout payments are larger the greater the riskiness of

the acquired company’s industry is consistent with agency theory, since the greater the firm’s risk the greater is the riskiness of the manager’s incentive

354 .

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compensation. The higher is the risk averse manager’s compensation risk, the higher the rate of incentive compensation required to attain reservation utility. Larger earnout payments when greater growth options are present is consistent with agency theory. Two reasons are: •

Firms with growth options face high risk if attaining the growth is subject to factors beyond the firm’s control, such as attaining approval of a new drug or successful defence of a patent violation lawsuit. Then, risk averse managers require a higher rate of incentive compensation to attain reservation utility.

•

High manager effort is particularly important for firms with growth options if the growth is to be realized. For example, the anticipated growth may involve new technologies which require considerable effort and skill of existing management to operationalize and market. To motivate high effort, a high proportion of compensation based on some risky performance measure is required.

Note: Either a risk-based or an effort-based argument is acceptable. The reason why the ratio of share value to market value (Tobin’s q) is commonly used as a measure of a firm’s potential for future growth derives from efficient securities market theory. Investors will be aware of the firm’s growth potential and as a result the firm’s share price will include the expected payoffs from that growth. Net income (hence book value) will not recognize these payoffs until realized (i.e., recognition lag). Consequently, the greater is the market’s growth expectations the greater is the ratio of market value to book value. b.

This finding is consistent with agency theory concepts. In agency

theory, net income is used as a performance measure when the payoff is not known until after the contract period is ended. The longer the period until the payoff is realized, the greater is the riskiness of the ultimate 355 .

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payoff amount, and the less precise is net income (or other accountingbased variable)) as a performance measure. A riskier performance measure requires higher incentive compensation (i.e., payments under a two or three year earnout period will be higher than for a one year period) if the risk averse manager’s reservation utility is to be attained. In effect, if manager effort needs to be maintained for a longer time, the earnout period must also extend over that longer time. c.

In general, net income is a more sensitive performance measure

than sales, since to generate net income, and ultimately payoff, more than sales effort is required. Managers must also devote effort to short-run matters such as supervision, advertising, production as well as longer-run effort such as planning and R&D. It is quite possible, for example, for a manager to generate high sales in the short run while shirking on other effort dimensions. However, sales are generally a more precise performance measure than net income, since fewer accruals are involved and there is less scope to manage sales than net income. For senior managers, the trade-off between sensitivity and precision generally tends to be tilted towards net income, since the importance of motivating both short- and long-run manager effort dominates the greater precision of sales. For a target with high risk and/or high growth options, however, the precision of net income is quite low, due both to recognition lag for rapidlygrowing firms and likely greater scope to manage earnings. Also, high firm risk leads to higher compensation risk when this is based on net income rather than sales. Consequently, the greater use of sales as a performance measure is consistent with agency theory since this seems to be the most efficient point on the sensitivity/precision trade-off when firm risk and growth is high. 356 .

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Additional Problems

9A-1. A manufacturer of farm equipment is headed for financial distress. Bonuses of management are based on net income relative to budget. There has been a recent change in management, occurring in early 2001. To the surprise of the new manager, the outgoing manager had sharply increased 2000 production, resulting in excessive levels of inventory on hand at the end of 2000. The manufacturer uses absorption costing for its inventories. Required a.

Explain why the old management increased production and inventories.

How might the remuneration plan of management be changed to reduce

the likelihood that this would happen in the future? (CGA-Canada)

9A-2. Suppose there is a company with a number of divisions that are profit centres, all sharing a common production facility (for example, a machine shop). The user divisions are always submitting rush orders to the operator of the common production facility. The division involved (division A) claims the order is urgent and that delay will result in significant profit losses to the company, a claim that is very difficult for the operator of the common facility to verify or refute. What sometimes results is a job being given priority, which causes a delay of some other division’s job, where the cost of delay to the company (forgone profits due to, say, impatient customers going elsewhere) is well in excess of the cost of delay to division A. Assume that each division manager receives a bonus based solely on the profits of his or her division, in addition to fixed salary.

357 .

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Required a.

Explain why the behaviour of division A’s manager is predictable, in terms

of agency theory.

Can you think of a solution to this agency problem? Explain why your

solution works.

(CGA-Canada)

9A-3. The shareholders of UVW Ltd. are unhappy about the top manager’s performance. While the manager’s effort in running the firm cannot be observed, it is felt that he or she puts in effort amounting to about 40 hours a week. The manager’s annual salary at present is $160,000. A new incentive contract is being considered by the shareholders, whereby the manager would receive a salary of $100,000 per annum plus a bonus of 25% of reported net income before salary and bonus. You are asked to analyze the expected impact of the new bonus plan on the manager. You estimate that if the manager puts in about 60 hours per week (a1), net income before manager remuneration will be $1,040,000 per annum with probability of 0.7, and $90,000 per year with probability of 0.3. Under the present salary-based remuneration, whereby the manager’s effort is 40 hours per week (a2), analysis of past profitability shows that annual net income has been $1,040,000 with probability of only 0.1 and $90,000 with probability of 0.9. You also ascertain that the manager’s utility for money is equal to the square root of the money received, and that disutility for effort is four times the number of hours worked per week. Required a.

Show calculations to verify that under the present salary-based

remuneration plan the manager will prefer to work 40 hours per week over 60 hours.

358 .

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Which act, a1 or a2, will the manager prefer under the new incentive

contract? Show calculations.

A new accounting standard is proposed that, while it will not change future

expected net income, will greatly increase the volatility (i.e., reduce the precision) of net income. Explain why the manager would object to the proposed new standard.

9A-4. One of the problems of entering into contracts, including executive compensation contracts, is incompleteness. That is, it is generally impossible to foresee all relevant events that might happen and build provisions for them into the contract. An example of contract rigidity in the face of an unforeseen event appeared in the Wall Street Journal (April 15, 1993) in an article entitled “Firms Get Around Big One-Time Earnings Hits to Save Executive Bonuses.”

The article discussed SFAS 106, which required that firms accrue employees’ post-retirement benefits, rather than waiting until they are paid. The article stated that because of SFAS 106, “many compensation committees want to use operating earnings—not net after the accounting change—to calculate top managers’ bonuses.” For example, Chrysler Corp., which had a charge for retiree health costs of $4.7 billion in 1993, planned to ask its shareholders if it could exclude the charge to calculate bonuses. However, there was opposition by the United Shareholders Association, who believed that charges such as postretirement benefits “should be deemed a regular business cost, not an unusual expense to be ignored by board compensation committees.” However, consulting firm Wyatt Co. “says it’s simpler to exclude the new annual charges than to alter bonus formulas.”

359 .

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Required a.

If you were a Chrysler shareholder, would you agree to this request?

Explain why or why not. b.

If you were a senior Chrysler executive affected by SFAS 106 and your

request was turned down, how would you react? Explain why.

9A-5. Mr. Kao, the owner of Kao Industries, wants to hire a manager to operate the firm while he takes an extended trip abroad. He wants the manager to work hard (60 hours per week) rather than shirk (40 hours per week). The payoff table for Kao Industries under each alternative is as follows: Kao Industries Payoff Table for Year NET INCOME FOR YEAR

PROBABILITY

(a1 = 560 hours)

(a2 = 540 hours)

$400

0.7

0.2

200

0.2

0.3

0.1

0.5

(before manager remuneration)

Mr. Kao is negotiating with a potential manager about the remuneration contract. The manager’s disutility for effort for the year is: Disutility of effort =

h2 800

where h is the number of hours worked per week.

360 .

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Required a.

Show calculations to verify that for a fixed annual salary paid to the

manager, Mr. Kao will prefer that the manager work hard. Mr. Kao is risk-neutral.

For any fixed annual salary, will the manager prefer to work hard or to

shirk? Explain.

Suppose that Mr. Kao offers the manager a fixed annual salary of $10,

plus 10% of net income. The manager’s utility for money is equal to the square root of the money received. Assuming that the manager takes the job, which act would he or she take? Show your calculations. (CGA-Canada)

361 .

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9A-6. Henri owns and operates a small successful sporting goods store. He has not had a holiday for three years. He decides to take an extensive one-year trip around the world and is negotiating with Marie to operate the store while he is away. The store’s earnings are highly dependent on how hard the manager works, as per the following table:

a1: Work Hard

a2: Shirk

Net Income Prob. Net Income Prob.

x1: High Earnings

$300

0.7

$300

0.2

x2: Low Earnings

$80

0.3

$80

0.8

Marie, like most people, is risk-averse and effort-averse. Her utility for money is equal to the square root of the amount of money received. If she works hard, her effort disutility is 2. If she shirks, her effort disutility is 1.6. Marie informs Henri that she is willing to accept the manager position but that she must receive at least an expected utility of 3.41, or she would be better off to work somewhere else. Henri, who is not an agency theory expert, offers Marie a salary of $20 plus 5% of the store earnings (after deducting $20 salary from the earnings in the table). Marie immediately accepts. Required a.

If Henri hires her, which act will Marie take? Why did she immediately

accept? Show calculations. b.

Henri’s bank manager, to whom he has turned for advice, suggests that if

he hires an agent, the store’s annual earnings should be audited by a professional accountant. Explain why. 362 .

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Assume that Henri hires Marie under the contract proposed, that is, $20

salary plus 5% of profits after salary. Shortly after he leaves, a new accounting standard requires that estimated customer liability be accrued. This lowers the high earnings to $286 and the low earnings to $40 in the table above (i.e., before salary). The payoff probabilities are unaffected. Which act will Marie now take? Show calculations. Will Marie be concerned about the new standard? Explain why or why not.

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Suggested Solutions to Additional Problems 9A-1. a.

It appears that the old management increased production and inventories

in order to maximize its bonus. This is because, under absorption costing, an increase in inventories will absorb overhead costs that would otherwise be charged against the current year’s net income. Given that the firm is headed for financial distress, increasing production and inventories may have been a way to report sufficient profits that the old management would receive a bonus. b.

Management should be given a longer-run perspective in operating the

firm than is created by basing bonus on reported net income for the year. A way to do this would be to base management compensation, at least in part, on share price performance. Management would realize that operating policies that increase current profits at the expense of future profits would not be in its own interests, since share price would respond negatively as soon as the production increase and resulting increase in inventories became known. Note that for this argument to hold, management must be required to hold shares received as compensation, possibly even beyond retirement or replacement. An alternative would be to base the bonus on longer-run net income, such as a 3 or 5-year average. It is unlikely that a policy such as manufacturing for stock could be sustained this long, since the inventory would have to be financed. Consequently, the likelihood that management would again unduly increase production is reduced. 9A-2. a.

The company’s divisionalized form of organization, together with bonuses paid

based on divisional profits, creates a conflict situation between division managers. In agency theory, each manager is assumed to maximize his or her own expected utility. Consequently, division managers compete with one another for rush orders, regardless of the effect on overall company profits.

364 .

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A solution would be to base bonuses at least in part on overall company profit.

Then, division managers know that their bonuses will suffer if they attempt to push through a rush order for their own division that results in sufficiently higher costs to another division that overall company profit is reduced. A possible disadvantage of this solution would arise if (as is likely) overall company profit is less correlated with the effort of a division manager than is divisional profit. Then, the incentive effect (i.e., the sensitivity) of the compensation contract is lower. The firm would have to increase incentive by loading more risk onto the division managers, for example by lowering salary and raising profit share, holding expected compensation constant. For risk-averse managers, this would lower their expected utility of compensation, so that their expected compensation would have to be raised to enable them to attain their reservation utility. This solution works if the increased expected manager compensation is less than the order delay costs to the company under the old contract. Note: It is assumed implicitly above that each manager knows only his or her own effort. It may be, however, that division managers may have information about the effort levels of other division managers as well. Then, the principal can design a more efficient incentive contract, based on overall company profit, that exploits this joint effort knowledge. See the discussion of the paper of Arya, Fellingham, and Glover (1997) in Section 10.2. However, the assumption of Arya, Fellingham and Glover that each division manager knows the effort of the others can be questioned in our context, since divisional contributions to overall firm profit can be difficult to assess objectively. For an interesting article which questions the rewarding of managers and employees on the basis of firm-wide performance, see “Just desserts,” The Economist (January 20, 1994), p.71.

9A-3. a.

If the manager works 60 hours per week (a1), his/her expected utility is: 365 .

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EU(a1) = 160,000 − 60 × 4 = 400 - 240 =160 If the manager works 40 hours per week (a2), his/her expected utility is: EU(a2) = 160,000 − 40 × 4 = 400 -160 = 240 Therefore, the manager will prefer to work 40 hours per week. b.

Under the new plan, the manager’s expected utility for a1 is: EU new ( a1 ) = 0.7 100,000 + 1,040,000 × .25 + 0.3 100,000 + 90,000 × .25 − 60 × 4

= 0.7 × 600 + 0.3 × 350 - 240 = 285 Under the new plan, the manager’s expected utility for a2 is:

EU new (a2 ) = 0.1 100,000 + .25 × 1,040,000 + 0.9 100,000 + .25 × 90,000 − 40 × 4 = 0.1 × 600 + 0.9 × 350 – 160 = 215 The manager will prefer to work 60 hours per week under the new plan. c.

Since the manager is risk averse, an increase in the volatility of expected

future bonuses will decrease expected utility, holding the expected value of bonuses constant. Given contract rigidity, the manager will object to the new standard because the expected utility of remuneration is lower. 9A-4. a.

If the request is granted, a shareholder would realize that this would result

in a higher bonus to managers, given the bonus formula. As a result, the shareholder may disagree with excluding the charge, particularly if he/she, like 366 .

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the United Shareholders Association, felt it was a valid business expense. This would be especially the case if the shareholder felt that the manager was already well-paid. Then, the bonus contract would be rigid, or resistant to change. A counter argument is that, according to agency theory, the lower manager compensation, if the charge is included, may cause the manager’s expected utility to fall below its reservation level. Then, the manager may leave the firm. To avoid this, the shareholder may agree to exclude the charge. Another argument against including the charge is that the manager may bias or manipulate reported earnings to make up for the shortfall. b.

Agency theory predicts the following reactions by an affected manager: •

The initial reaction would be an increase in manager effort. For a risk averse manager, a lower bonus as a result of the charge for postretirement benefits would raise the expected marginal utility of compensation. Then, since a rational, effort-averse manager will choose effort level so as to equate the expected marginal utility of compensation with the marginal disutility of effort, effort will rise to restore the manager’s equilibrium. In less technical terms, the manager will work harder so as to make up some of the lost compensation.

•

A combination of lower expected utility of compensation and greater effort could lower the manager’s expected utility below its reservation level. Indeed, it would do so, since the agency models of this chapter assume that the manager receives exactly his/her reservation utility. Then, the manager may leave the firm, or request a higher share of earnings for bonus purposes.

•

The manager may react against the new accounting policy. This could result in lobbying to have the new standard repealed or 367 .

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amended and/or in biasing (i.e., managing) reported net income so as to counter the effects of the standard on reported profits.

9A-5. a.

Let the fixed annual salary be $w. Then, if hours worked are: •

a1 (60 hours per week): Mr. Kao’s expected payoff is: 400 × 0.7 + 200 × 0.2 + 0 × 0.1 - w = 320 - w a2 (40 hours per week):

•

Mr. Kao’s expected payoff is: 400 × 0.2 + 200 × 0.3 + 0 × 0.5 - w = 140 - w Since his expected payoff is higher for any fixed w, Mr. Kao will prefer that the manager take a1. b.

The manager will prefer to shirk with a fixed annual salary. This is

because the same remuneration is received regardless of the act taken but the disutility of shirking (402/800) is less than that for working hard (602/800). c.

If the manager works hard (a1), expected utility EU of the manager is: EU(a1) = 0.7 U(10 + 40) + 0.2 U(10 +20) + 0.1 U(10) - 602/800 = 0.7 × 50 + 0.2 × 30 + 0.3 × 10 − 3,600 / 800 .

368

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= 4.95 + 1.10 + .32 - 4.50 = 1.87 If the manager shirks (a2), expected utility of the manager is: EU(a2) = 0.2 × 50 + 0.3 × 30 + 0.5 × 10 − 1,600 / 800 = 1.41 + 1.64 + 1.58 – 2.00 = 2.63 Therefore, the manager will still prefer to shirk. The manager’s disutility for effort is sufficiently great that it outweighs the higher expected compensation under a1. Note: In questions such as this that involve the calculation of expected utility when utility of money is non-linear, students often tend to calculate the utility of the expectation rather than the expectation of the utility. For example, in the first part of c, many students calculate the expected compensation ($42) first, then take the square root, giving EU of 6.48 - 4.50 = 1.98, which is incorrect for a risk averse decision maker. Even though I warn them in advance, students will often make this error. 9A-6. a.

If Marie works hard (a1), her expected utility is: EU(a1) = 0.7 (20 + .05 × 280)1/2 + 0.3 (20 + .05 × 60)1/2 – 2.00 = 0.7 × 341/2 + 0.3 × 231/2 – 2.00 = 0.7 × 5.83 + 0.3 × 4.80 – 2.00 = 4.08 + 1.44 – 2.00 = 3.52

If Marie shirks (a2), her expected utility is: EU(a2) = 0.2 × 5.83+ 0.8 × 4.80 – 1.60 369 .

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= 1.17 + 3.84 – 1.60 = 3.41

Marie will work hard. She accepts immediately because by working hard she receives more than her reservation utility of 3.41.

The bank manager is concerned that if the low earnings state happens (as

it will with probability 0.3), Marie, who will control the store’s accounting system while Henri is gone, may manage earnings upwards, or simply falsely report high earnings, so as to receive the high compensation. An audit according to GAAP will protect Henri against this possibility.

Marie’s expected utilities are now: EU(a1) = 0.7 (20 + .05 × 266)1/2 + 0.3 (20 + .05 × 20)1/2 – 2.00 = 0.7 × 33.301/2 + 0.3 × 211/2 – 2.00 = 0.7 × 5.77 + 0.3 × 4.58 – 2.00 = 4.04 + 1.37 – 2.00 = 5.41 – 2.00 = 3.41 EU(a2) = 0.2 × 5.77 + 0.8 × 4.58 – 1.60 = 1.15 + 3.66 – 1.60 = 4.81 – 1.60 = 3.21

Marie will continue to work hard. However, she will be concerned about the new accounting standard, because she now receives only her reservation utility of 3.41, whereas before she received 3.52.

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CHAPTER 10 EXECUTIVE COMPENSATION 10.1

Overview

10.2

Are Incentive Contracts Necessary?

10.3

A Managerial Compensation Plan

10.4

The Theory of Executive Compensation 10.4.1 The Relative Proportions of Net Income and Share Price in Evaluating Manager Performance 10.4.2 Short-Run and Long-Run Effort 10.4.3 The Role of Risk in Executive Compensation

10.5

Empirical Compensation Research

10.6

The Politics of Executive Compensation

10.7

The Power Theory of Executive Compensation

10.8

The Social Significance of Managerial Labour Markets that Work Well

10.9

Conclusions on Executive Compensation

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LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

To Establish the Desirability of Incentive Contracts

When people are exposed to agency theory for the first time, a common reaction is to reject it because they feel that, almost by definition, managers do not need incentives to want to work hard. I counter this argument by asking the class whether they would work hard in this course if I was to cancel the final exam. However, in a multi-period context, the reaction has to be taken seriously. Fama (1980) must have had a similar reaction, and his argument that market value and reputation considerations will eliminate the shirking problem is worth outlining. Fama’s argument can be questioned, however, from both theoretical and empirical perspectives. In an undergraduate course, I do not pursue the theoretical issues; but the empirical perspective is worth developing. The first empirical evidence that reputation effects do not fully eliminate moral hazard (other than casual observation that all large firms do have incentive contracts) of which I am aware is the paper by Wolfson (1985). Relevant parts of this paper are described in the text. However, I usually assign the first part of the paper itself as supplemental reading and work through selected parts of it in class, since the argument is tortuous. Pages 101-117 of the article, incl., and the text discussion in Section 10.2 are sufficient for the point to be made that Wolfson’s results suggest that reputation effects do not completely overcome moral hazard. I have added a second reference (Bushman, Engel, and Smith (2006)) for anyone who wishes to pursue this topic further. 2.

To Flesh Out Implications of Agency Theory for Executive Compensation

Executive compensation of financial institutions has come under considerable criticism following the 2007-2008 market meltdowns. Financial institutions are responding with some compensation changes, as illustrated by the outline of the Royal Bank of Canada (RBC) Executive compensation plan in Section 10.3. Suggested points to discuss are:

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As predicted by Holmström (1979), the RBC is complex. Of course, part of

this complexity arises because of the multi-period nature of real compensation plans, whereas Holmström’s agency model spans a single period. Nevertheless, the mixture of performance measures is consistent with Holmström’s prediction. (ii)

Managers bear risk. This is the other side of the coin from the incentive

effects of giving the manager a share of the payoff. The manager must bear risk so that working hard is credible to the principle ex ante. Thus, there are minimum stock ownership guidelines. For example, the CEO should hold stock with a value of 8 times salary. Also, the long-term incentives plan awards stock options. However, the amount of risk is controlled by filtering annual performance awards through the Compensation Committee of the Board, and by positioning total compensation at the median of a peer group of companies. Also, the use of stock options may help control downside compensation risk. (iii)

Discussion of the RBC plan, and the proposed changes, could usefully

proceed in conjunction with discussion of the incentive characteristics of stock options, which have been singled out as one of the reasons for opportunistic manager behaviour such as that of Enron, and of financial institutions leading up to the 2007-2008 market meltdowns. Note, in particular, the long term of the ESOs and the relatively slow rate of vesting. Are these restrictions enough to deter excessive risk taking? In this regard, see Theory in Practice 10.1. 3.

To Understand the Qualities Needed by a Good Performance Measure

The basic qualities needed are precision and sensitivity. Sensitivity is the rate of change of the performance measure with respect to effort—the more sensitive the measure, the greater the shift. Precision is the reciprocal of the variance of the density function—the more precise the measure the less likely it is that random state realization will generate a performance result greater or less than expected given the manager’s effort. Questions 13 and 19 of Chapter 9 illustrate sensitivity and precision for a 2-point earnings distribution.

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Instructors may wish to consider the analogy with relevance and reliability, although the two sets of concepts are quite different. Nevertheless, the need to trade-off is common to both, when net income is a biased predictor of the payoff. When net income is an unbiased predictor, the expected value of net income remains equal to the payoff, but better reporting can still increase precision (Example 9.3). 4.

To Evaluate the Role of Net Income in Compensation Plans in Relation to Stock-Based Performance Measures

The class readily sees the short-run decision horizon that may be induced by basing manager compensation on the current year’s reported income, and the longer-run horizon hopefully encouraged by stock-based compensation. Also, share price is more timely in capturing all the effects of current manager effort, such as R&D. Thus, stock-based performance measures are more sensitive than net income. However, the class also sees that stock-based compensation may be more volatile than compensation based on reported net income. That is, it is less precise since it is affected by economy-wide events that may have low informativeness about manager effort. It is worth emphasizing that excess volatility can reduce contracting efficiency – for a risk averse manager, greater volatility of the performance measure will require higher average pay to maintain reservation utility, and will discourage the taking of risky projects. However, too little risk discourages effort. The key is to find a good balance between too much and too little risk imposed on the manager. The foregoing suggests that net income competes with stock price as a variable in compensation plans. I then suggest that both net income and share price (and possibly additional performance measures, such as attainment of personal goals) are desirable components of the plan, consistent with Holmström’s (1979) analysis. Also, I bring out that we can think of manager effort as a two-dimensional variable – call it long-run effort and short-run effort – and that the relative attention that the manager gives to each dimension can be controlled by the proportion of current net income-based and stock-based compensation in the compensation plan. This argument is based on the analysis in Bushman and Indjejikian (1993). 374 .

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Instructors who wish to develop further the concept of multi-dimensional effort can discuss the concept of non-congruency of a performance measure explained in optional Section 10.4.2. However, this section can be ignored with little loss of continuity. Having established that there is a role for net income in compensation plans, I then ask whether the measure of income should be historical cost-based, or current value-based as per the measurement perspective of Chapters 6 and 7. I argue that historical cost-based accounting has greater precision, due to the random factors that can affect fair valuebased income but which are low in informativeness about manager effort (e.g., changes in market prices). This contracting role for net income is a possible reason why historical cost-based accounting has such “staying power” in the mixed measurement model, and raises the question of whether historical cost-based or current value-based income measures are preferable in compensation plans. 5.

To Introduce Empirical Evidence on the Role of Net Income in Compensation Plans

The predictive ability of the theory of executive compensation needs to be tested empirically. Beginning with the 1987 paper by Lambert and Larcker, the empirical research supports the compensation theory, much like the empirical research concerning investor reaction to accounting information supports the rational investor and market efficiency theory. 6.

To Evaluate Political Aspects of Executive Compensation

Executive compensation has attracted a lot of media and public attention, often focusing on the question of whether North American managers are overpaid, particularly in relation to their counterparts in other regions. This question is an excellent one with which to motivate student interest in the theory. Problems 4, 12, 14, 15, 17, 18, and 19 deal with various aspects of possible executive over-compensation.

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I also remind the class of the problems of measuring the stock options component of executive compensation that were discussed in Section 8.6. These problems arise in large part because the Black/Scholes formula assumes that options are held to maturity whereas ESOs may be exercised after vesting but prior to maturity. This tends to lower the ESOs’ fair values relative to Black/Scholes. Recall that, to compensate for this, accounting standards suggest using the expected time to exercise in Black/Scholes. Also, it should be noted that since managers are, in effect, forced to hold their ESOs from the grant date to vesting, this further reduces the ESO value to the manager since in general, fair value assumes that assets and liabilities can be readily sold if desired. The paper by Hall and Murphy (2002) brings out the decline in the value of an option to a risk-averse manager, relative to its Black-Scholes value, as the manager’s ability to sell the option is restricted. Theory and Practice 10.5 and Problem 13 re Zion’s Bancorporation illustrate this effect. The main point I make as a result of these considerations is that the value of ESOs to the manager is likely considerably less than the amounts one sees in the media, which typically take the number of options exercised times share market value as their measure of the options compensation. 7.

The Power Theory of Executive Compensation

I suggest using this section to bring out the point that just as rational investment and efficient markets face competing theories, so does the theory of executive compensation. The power theory argues that managers use their influence in their organizations to receive more than reservation utility, implying low efficiency of managerial labour markets and increasing the scope for financial reporting of manager compensation. Discussing the parallelism here, I hope, helps the students to better understand both theories of reporting to investors and theories of manager compensation.

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

The 10% bonus plan is designed to overcome the moral hazard problem

which arises because the shareholders cannot observe management’s effort in operating the firm. If they received a straight salary, managers may be tempted to shirk. By giving managers a share in profits (which are informative about effort and payoff), their tendency to shirk is reduced. The lack of a cap could encourage the manager to undertake risky projects, since if these projects pay off the manager will receive high compensation. However, if they do not pay off, the lowest compensation the manager receives is zero (this assumes a bogey-- the manager does not have to pay the firm 10% of any losses). If shareholders are diversified, a reasonable level of firm risk may be in their best interests. However, if excessively risky projects are undertaken, the probability of financial distress, such as debt covenant violation or bankruptcy, is increased. This may not be in shareholders’ best interests since it is they that suffer any resulting losses. Since income tax expense may not be very informative about manager effort, Miracle-J Corp. must feel there is no need to deduct income tax in arriving at profits subject to bonus. A performance measure should be as informative as possible about manager effort. Evidently, Miracle-J Corp. believes that before-tax profit is such a measure. Note, however, that this will reduce management effort devoted to minimizing taxes. b.

Reasons for the Employee Stock Option Plan: •

To strengthen employees’, including senior managements’, incentive (in addition to the bonus plan) to work hard on the firm’s behalf. Since the value of stock options depends on share price performance, this component of compensation is consistent with the analysis of Hölmstrom (1979), which shows that more than one performance measure can increase contracting efficiency. 377 .

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The plan may be intended to give senior management a longer-run perspective in operating the firm. As demonstrated by Bushman and Indjejikian (1993), the length of the manager’s decision horizon can be controlled by the relative proportions of short- and long-term incentives. Also, this gives the firm’s compensation committee some flexibility to change the decision horizon. For example, if short-term profit goals are not being met, the proportion of compensation based on profits can be increased.

•

To motivate a broader segment of the firm’s workforce – the plan applies to employees in general, not just officers. The firm may feel that a bonus plan for all employees may require too much cash. Effort motivation can be achieved, without direct expenditure of cash, by issuing ESOs. There is an opportunity cost of issuing ESOs, however, This cost shows up as dilution of the equity of existing shareholders, since shares issued under ESOs are issued for less than market value. Also, substituting ESOs for bonus may change the employees’ decision horizon. Note: While the ESO plan may encourage employee cooperation, it may instead lead some employees to “free-ride” on the efforts of others. Also, it could lower employee morale if share price, hence ESO value, falls or does not increase. Since lower level employees have little or no say on strategic decisions, they may feel that a poorly performing share price is not their fault. (Of course, under a bonus plan, they may feel the same way if net income falls.)

To a considerable extent. Due to contract incompleteness and rigidity,

accounting policies and changes in GAAP that affect reported net income would have economic consequences for management. For example, bonus awards will be affected, either in terms of expected value or volatility, or both. Also, changes in GAAP can affect the likelihood of debt covenant violation, which could incur costs 378 .

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by constraining the firm’s operations. Consequently, management is likely to look closely at accounting policies and any changes in these policies induced by changes in GAAP. Also, to the extent it does not accept full securities market efficiency, management may feel that accounting policies and GAAP changes that lower reported net income may cause share price to fall, thereby lowering the value of stock-based compensation such as ESOs. 2.

Note: Instructors who assign this problem may wish to refer students to Chapter 7, Note 22, which points out that risk goes both ways. That is, the relevant ex ante compensation risk measure for a manager who trades-off risk and return is a measure of the dispersion of compensation, such as its standard deviation. Students have a tendency to think primarily of controlling downside risk in this question. While valid, this view of risk is more of an ex post concept than an ex ante one. That is, following state realization, the manager may react negatively to reduced compensation if the realization is unfavourable, but would be unlikely to react this way if the realization is favourable. Before state realization, however, a “2-sided” concept of risk is appropriate. The suggested answers below use both ex ante and ex post views of compensation risk. a.

Reasons why it is important to control or reduce the risk imposed on

managers: •

Since managers are likely to be risk averse, they will trade-off risk against expected returns ex ante, and will demand an increase in the expected level of their compensation as risk increases so as to maintain their reservation level of utility. This will increase the firm’s average compensation cost.

•

Excessive ex ante risk may cause managers to undertake only safe (that is, less risky) projects. Shareholders’ interests may be better

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served by riskier projects since shareholders can diversify away firmspecific risk. •

Excessive risk may cause the manager to engage in extensive hedging activities. This is costly to the firm and could possibly lead to the use of derivatives for speculation rather than risk management.

Different ways of reducing risk are: •

The bogey and cap in a bonus plan reduce risk ex ante, because they impose bounds on the manager’s bonus.

•

Existence of stock options in the compensation package reduces downside risk. If the stock price rises the manager stands to gain but the lowest an ESO can be worth is zero.

Note: If stock price falls substantially, and for an extended period, the exercise price of managers’ stock options may be lowered by the compensation committee of the Board. This possibility further lowers managers’ risk, but has incentive connotations. See Problems 14 and 15. •

Use of relative performance evaluation reduces risk because the common risk faced by all firms in the comparison group is filtered out. Thus a manager may receive a bonus or stock-based award even if reported results are poor if they are not as poor as the industry average.

•

Existence of a compensation committee to monitor managerial compensation reduces risk because this committee is likely to consider exceptional or unexpected circumstances in it deliberations. The committee may award a bonus even when firm performance is poor if it feels the manager is deserving. However, compensation committees are often criticized for awarding bonuses when the manager is not deserving. 380 .

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Earnings management, that is, the ability to choose from a set of accounting policies, reduces risk both ex ante and ex post. Earnings management helps managers to reduce the effect of unforeseen state realizations on reported net income. However, the manager may abuse earnings management to cover up shirking, thereby receiving an undeserved bonus.

•

Golden handshakes. These provide severance payments to managers who leave the firm. These reduce risk for the manager since it is possible that the firm be taken over or may enter financial distress, despite the manager’s best efforts. Such events frequently result in the termination of the current manager.

If too much compensation risk is eliminated, the manager may shirk. Agency theory tells us that if effort is to be motivated the manager must bear some risk. An efficient contract imposes an optimal amount of risk, not minimal risk. c.

Such requirements are imposed so that managers do not reduce their risk

by selling off their firms’ shares (which are subject to firm-specific risk) and buying diversified portfolios (with little or no firm-specific risk) from the proceeds of the sale. Requiring managers to bear compensation risk maintains their incentive to exert effort, thereby controlling moral hazard. However, forcing the manager to hold company stock increases the manager’s compensation risk. The riskier the compensation, the higher must be the expected compensation if the manager’s reservation utility is to be maintained, resulting in higher average compensation cost over time for the firm. Also, excessive risk may encourage dysfunctional manager behaviour such as avoidance of risky projects (when these would benefit diversified investors) and excessive hedging. d.

Basing managerial compensation solely on share performance may impose

excessive risk on the manager because:

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Share price tends to be low in precision. Unless offset by higher sensitivity, the resulting increase in ex ante risk may require higher expected compensation to maintain reservation utility.

•

Hölmstrom (1979) shows that more than one performance measure can increase contracting efficiency. This supports the inclusion of net income as a performance measure in addition to share return.

•

Bushman and Indjejikian (1993) show that including both share price-based and net income-based components in the compensation package can control the length of the manager’s decision horizon. In some cases, for example if the firm needs to quickly reduce its costs, the firm may wish to shorten the manager’s decision horizon. It can do this by increasing the relative proportion of net income-based compensation since net income will respond quickly to reduced costs.

No, you should not agree. While cash is received, the amount is less than the market value of the underlying shares. Consequently, the firm will suffer an opportunity loss of the difference between exercise price and underlying share market value. Failure to record this expected opportunity loss understates compensation expense and possibly leads to excessive use of options as a compensation device.

The reason why the values of ESOs and restricted stock to a manager are less than their fair values is that compensation plans generally restrict the manager’s ability to diversify or eliminate risk by selling them. Since managers are assumed risk averse, forcing them to hold these risky assets reduces their worth (utility) to the manager to less than fair value, since fair value based on Black/Scholes and stock market value assumes unrestricted buying and selling.

A low pay/performance relationship is expected for large corporations for the following reasons:

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Too much downside risk on a manager reduces compensation contract efficiency since downside risk may induce dysfunctional behaviour such as excessive avoidance of risky projects and excessive hedging. Downside risk is reduced by a bogey in the compensation contract, which eliminates the possibility of the manager paying the firm if losses are incurred. But not requiring the manager to pay the firm if losses are incurred reduces the pay/performance relationship.

•

Many compensation plans impose a cap on compensation.

•

For large companies, the amount of increase in value over a year can be extremely large. Unless compensation is a very small proportion of this value increase, it would be excessive, even for a manager.

•

To the extent that special items are excluded in determining amounts of compensation awards, a low pay/performance relationship is generated, since these items then affect net income but not compensation.

•

Managers often receive large amounts of compensation upon leaving the firm (golden parachutes) even if the reason for leaving is poor performance.

•

To the extent the power theory of executive compensation is operative, managers use their power in the organization to attain excessive compensation, unrelated to changes in firm value. This reduces the pay/performance relationship both when compensation is not reduced following poor performance and when a compensation increase exceeds any increase in performance.

Firm A’s compensation plan suggests that the precision of net income is high, with reasonable sensitivity of effort relative to the sensitivity of share price. An example of an A-type firm is one with the volatility of net income low relative to the volatility of share price (e.g., low financial and operating leverage), low and stable R&D costs, and a short-term decision horizon. Then, it is more efficient for Firm A to base a high proportion of compensation on net income. 383 .

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For Firm B, its compensation plan suggests that the sensitivity of effort relative to share price is high, with reasonable precision relative to the sensitivity of net income. An example of such a firm is one with the volatility of net income high relative to the volatility of share price (e.g., high financial and operating leverage), with high and volatile R&D costs, and a longer-term decision horizon. Then, it is more efficient to base a high proportion of compensation on share price. Note that manager compensation is not completely based on net income or share price, however. This would give the managers an excessively short-run or long-run horizon, respectively, in operating the firm. Note: The question implicitly assumes that both firms’ earnings quality is similar. 7.

The reason derives from the Holmström demonstration (Section 9.6.1) that more than one performance measure can increase compensation contract efficiency. The reason for greater weight placed on non-financial measures relative to earnings-based measures for lower-level executives is that it becomes progressively more difficult to assign responsibility for corporate performance to lower level employees, due to the jointness of their efforts. This jointness reduces the sensitivity of both net income and share price-based performance measures for these employees. In effect, informativeness of corporate performance with respect to effort and payoff becomes lower as employees are farther down in the organization. Furthermore, the motivation of corporate performance measures becomes lower for lower-level employees since they perceive a less direct connection between their effort and corporate performance. While basing compensation on corporate performance may increase cooperation between lower level employees, it also creates a temptation to “free ride” on the efforts of others. Then, compensating such employees on the basis of corporate performance reduces contract efficiency. Consequently, lower level employees should be compensated more on their individual performance and less on corporate performance. 384 .

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Note: This argument assumes that individual performance measures can be measured with reasonable precision. 8.

The reason for requiring executives to hold company shares is to further align their interests with those of shareholders. Also, executives would be motivated to maintain a longer-run decision horizon. Note: Executives of financial institutions leading up to the 2007-2008 market meltdowns presumably held large amounts of company shares. Yet, executives of these firms did not seem to have a longer-run decision horizon. Possibly, other compensation components, such as bonuses and ESOs, motivated sufficiently short decision horizons as to overcome the effects of share holdings. Requiring stock holdings post-retirement is due to a concern that as executives approach retirement, their decision horizons shorten. If so, they may opportunistically manage earnings upwards, and/or take actions to increase earnings in the short run (e.g., reduce advertising, R&D, repairs and maintenance), so as to collect high cash bonuses. However, these actions may lower firm profits and share price in the longer term. Requiring executives to hold shares after retirement reduces this concern. Note: This argument can be related to maintenance of trust in the final period of the multi-period trust-based game illustrated in Section 8.10.3 (optional reading).

Reasons why TD would voluntarily expense its ESOs: •

To show a commitment to transparency, and high quality reported net income. This could lower its cost of capital by decreasing investors’ estimation risk.

•

TD may not have been a heavy user of ESOs. If so, the impact of expensing on net income would be moderate, at least relative to its 2003 net income of $1.076 billion.

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TD may have been planning to reduce its use of ESOs in view of the apparent adverse incentive effects (i.e., pump and dump, late timing) of ESOs and the resulting bad publicity surrounding their use.

•

TD may have been expecting a period of high earnings, so that net income could “stand” the charge without creating problems with debt covenants.

•

TD may have accepted securities market efficiency, in which case it would realize that moving ESO cost from the notes to the financial statements proper would have no direct effect on share price.

•

TD, being a large Canadian firm, may have been concerned about the political costs of high net income of $1.076 billion, and wanted to minimize current reported net income to avoid charges of excessive profitability.

•

TD may have realized that a new standard requiring ESO expensing was imminent, so it might as well start now.

10.

If securities markets are efficient, Microsoft’s share price would be

unaffected by the reduction in earnings since the switch generates little effect on the firm’s cash flows. Reasons why Microsoft’s stock price may fall include: •

The restricted stock has an exercise price of zero, unlike ESOs. The market may react to the reduced ESO cash flow to Microsoft, even though the amount was small.

•

If security markets are not fully efficient, the market may not properly interpret the reduction in reported net income.

•

Microsoft is a heavy user of stock compensation, based on the material amount of its stock-based compensation expense. Materially lower reported net income may increase the probability of debt covenant violation. The market would react adversely to this possibility. 386 .

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Investors may interpret Microsoft’s switch to restricted stock as an indication that the firm did not expect its share price to rise to the ESO exercise price for some time.

Reasons why Microsoft’s share price might rise: •

Lower net income may reduce political pressure resulting from excessively high earnings.

•

Switching voluntarily to a type of compensation that requires expensing may be a signal of inside information that Microsoft expects high future earnings.

•

Before share-based compensation expense, Microsoft’s 2003 earnings of $3.72 billion exceeded analysts’ estimates of $3.28 billion.

•

Investors may expect that eliminating the under water ESOs and replacing them with shares would improve employee motivation, effort, and retention.

Microsoft may have wanted to remove market concerns about pump and

dump, and other types of dysfunctional manager behaviour as documented by Aboody and Kasznik (2000) and Yermack (1997) (see Section 8.6). To the extent the market was concerned about such behaviour, share prices of all heavy ESO users would be affected. Since restricted stock is less subject to manager dysfunctional behaviour to maximize ESO value, switching to restricted stock with a 5-year vesting period would reduce market concerns about estimation risk, thereby lowering cost of capital. Microsoft may have anticipated the late timing ESO scandals (Section 8.6). Even if it did not engage in late timing itself, it could distance itself from the adverse publicity surrounding late timing by discontinuing its ESO plan.

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Furthermore, it may have become apparent to these firms that ESOs were not as efficient a compensation device as originally thought. To the extent they induced short-run dysfunctional behaviour, they had the opposite effect than intended. Restricted stock with a 5-year vesting period may be viewed as a more efficient compensation device to induce a longer-term employee horizon. 11.

The GE compensation plan seems likely to induce a balance of longer-run

effort, for the following reasons: •

The 5-year period before the cash flow and share price targets pay off. This encourages longer run effort since there will be time for longer-term projects to pay off. Projects that have a short-run payoff but which may depress company performance in the longer run (e.g., excessive cost-cutting) will be discouraged.

•

The share component of the compensation package. GE’s compensation package contains a large share component—the 125,000 share units based on beating the S&P 500 index, and the requirement to hold 6 times salary in company shares. Basing compensation on share price performance encourages longer-run effort, since an efficient market will see through effort that may depress earnings in the short run (e.g., R&D), and will bid up share price by the amount of the expected longer-term benefits. The plan does encourage some short-term effort, through the annual salary and bonus components. However, these are relatively small compared to the longer-term components. Even if the S&P 500 index and GE’s current $30 share price stay flat over the next 5 years, meeting both 5-year targets will yield (250,000 × 30) $7,500,000. To the extent share price increases over 2003-2008, this amount is even greater.

Dysfunctional effects of too much compensation risk include:

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Adoption of only safe operating policies, offering low expected returns. These may not be in the best interests of diversified investors.

•

Excessive hedging to reduce firm-specific risk, when shareholders may be able to do this at less cost through diversification.

•

Higher average compensation to manager to compensate for the excessive risk, otherwise manager may leave if reservation utility not attained.

Operating cash flows have lower precision than net income since they are

lumpy, and thus more subject to random events that are not informative about effort and future payoffs. For example, a postal strike may delay the receipt of cash until next period, so that cash flow is less informative about effort than net income, which would accrue the amount receivable. Similarly, cash payments may be deferred if the firm runs short of cash, whereas the related expenses would be accrued as accounts payable. Operating cash flows may also be less sensitive than net income. For example, a manager may work hard this period to attract new customers and secure large new sales. However, receipt of cash is unlikely until next period, thereby lowering its informativeness about current period’s effort and the ultimate payoff. However, net income is more subject to earnings management than cash flow. This lowers sensitivity, since the manager may manage earnings to cover up shirking on effort. Presumably, this is the reason that GE uses cash flow rather than net income in this component of its compensation. We conclude that operating cash flows are a less precise performance measure than net income. However, it is not clear if they are also less sensitive. This depends on the extent of earnings management.

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Eliminating unusual events from the operating cash flow performance measure seems to be a risk-reducing device. Such events are often hard to predict and are large in amount. Eliminating them reduces risk by increasing the precision of the performance measure. Alternatively, eliminating unusual events may be designed to increase sensitivity, since they may not be very informative about manager effort and ultimate payoff. The effect on manager motivation may be to increase effort, since it may be more difficult to disguise shirking by managing cash flow than by managing net income. However, if all unusual events are removed from a performance measure for compensation purposes, this reduces manager risk. Too little risk will reduce manager effort. d.

The following points should be considered: •

There may be some incentive to pump up share price prior to the grant date if the number of restricted shares to be granted depends on share price performance.

•

Restrictions on disposal during the vesting period reduce the temptation to pump share price during that period. This is especially so if the vesting period is long—5 years in the case of GE. To the extent restricted stock vests later than ESOs, the temptation to pump, and the ability to dump, are reduced.

•

Once the vesting period of restricted shares has passed, there is an obvious temptation to pump so as to increase share value and/or increase the proceeds of dumping.

We conclude that restricted stock is subject to pump and dump behaviour but to a lesser extent than ESOs. 12.

The argument for disclosure of compensation information of senior

executives is to motivate manager effort and to enable managerial labour markets 390 .

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to work better. Manager effort is motivated because the executive knows that the disclosures reveal information about the compensation committee’s evaluation of the managers’ performance and the types and amounts of compensation awarded. The manager also knows that investors will relate this compensation to firm performance. If, due to low effort, performance is poor relative to compensation, the manager’s reputation will be damaged and reservation utility for future compensation contracts will be reduced. The disclosures enable managerial labour markets to work better for the same reason. Given the compensation committee’s evaluation of the managers’ performance and the types and amounts of compensation awarded, market forces will drive compensation down if compensation appears excessive, and vice versa. These forces will show up, for example, in investors selling their shares if compensation is not reduced and/or raising objections in the media and at shareholders’ meetings. In rejecting this argument, Mr. Lamoureux must feel that the managerial labour market is not fully efficient. For example, he may feel that the power theory of compensation may better describe the labour market’s operation. Then, market forces are less powerful, and it is possible for managers to receive more or less compensation than the value of their services warrants. Consequently, more disclosure may simply encourage other managers to seek pay increases to match their higher-paid peers. b.

The answer depends on how well the managerial labour market works. If it works

well, RBC’s relating of its total compensation to the median of its Peer Group will have no effect on compensation levels in the banking industry. Managers will continue to receive compensation consistent with the value of their services given by all publicly available information, including information in the pay disclosure rules. However, if managerial labour markets do not work well, possibly because the power theory is operative, managers may receive more compensation than required to meet their reservation utility. As Mr. Lamoreux fears, they may feel that they are entitled to higher compensation than that of the Peer Group median, and may use their power to 391 .

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convince the compensation committee that higher pay (higher than justified by their market value) is justified. If enough managers feel this way, the level of pay in the banking industry will ratchet upwards over time. 13.

Reasons for a market-based approach to stock option expense: •

Zions may feel that estimates based on models such as Black/Scholes are unreliable, and may overstate ESO expense. Sources of unreliability include possible bias due to the need to estimate the timing of ESO exercise by its employees, and also due to estimates of parameter inputs needed by models, such as share price volatility.

•

Zions may want to increase reported net income by reducing ESO expense. From an efficient contracting perspective, higher reported net income may reduce the probability of debt covenant violation. From an opportunistic perspective, higher net income may lead to higher manager compensation.

•

If Zions does not completely accept securities market efficiency it may feel that lower ESO expense and resulting higher reported profits may lead to higher share price.

Model-based estimates of ESO value measure the cost to the company. This cost derives from dilution of existing shareholders’ interest in the firm. This dilution is measured by the opportunity cost arising from issuing new shares at ESO exercise price, which is less than market price of the issued shares. Model-based estimates of ESO value are estimates of this opportunity cost to the company. However, ESOs have restrictions attached. They cannot be exercised until the exercise date. Then, senior employees cannot diversify the risk of share price changes during the time period up to exercise date, since they cannot work for more than one firm at a time. Consequently, ESOs are worth less to 392 .

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a risk averse employee than opportunity cost to the firm. For example, Hall and Murphy (2002) estimate that for a moderately risk-averse individual, the value of an ESO to that individual is only about 40% of its Black/Scholes value. By selling securities equivalent to its ESOs to risk averse investors, the market price so established approximates their value to the employee, not their opportunity cost to the company. c.

No, you do not agree. Since net income, hence stock option expense, should be measured from the perspective of the company, its opportunity cost is the relevant measurement basis. Note: You may agree if you feel that investors are risk neutral. You may also agree if you feel that the large number of estimates needed to apply Black/Scholes to ESO valuation creates an opportunity for sufficient error and bias by management that the greater reliability of a market-based approach outweighs its lower relevance.

14.

Reasons for repricing ESOs: •

Senior managers may opportunistically seek to benefit themselves at the expense of existing shareholders by lowering (i.e., repricing) the exercise price of their ESOs. This increases the dilution of exiting shareholder interests. This behaviour is more likely if corporate governance is poor.

•

Power theory of executive compensation. CEOs may use their power and influence in the organization to benefit themselves at the expense of existing shareholders. If the CEO is also Board chair, his/her power in the organization is increased.

•

Efficient contracting theory. By reducing exercise price, key employees may be induced to stay with the organization if, without repricing, their expected utility of compensation was below its reservation level. Also, even if employee expected utility was still 393 .

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above reservation level, their motivation to exert effort would be increased if they felt that the current share price was so far below exercise price that it was unlikely their ESOs would ever be in the money. •

Competition for competent employees. To the extent that their expected utility of compensation falls below reservation utility due to zero ESO value, current employees may leave the company, with the most competent the first to leave. This effect is stronger the greater the competition for talent in the industry. Thus, firms in hi-tech, research intensive industries, and financial firms, have strong incentives to reprice.

•

Share price volatility, reflecting the underlying riskiness of the firm’s environment. The events leading up to repricing, leading to a decline in stock price, suggest the the firm’s riskiness may have increased. The potential for a stock option to increase in value is greater the greater is firm risk and resulting share price volatility. Consequently, repricing becomes a more effective effort motivator as firm risk increases.

•

Extent to which current options are under water. The higher the excess of exercise price over current share price for currentlyoutstanding options, the less incentive for employees to work hard to create a share price increase. That is, they may “give up” and/or seek alternative employment. Repricing increases the incentive to work hard to the extent that employees see an increase in option value as more attainable.

•

Minimizing total compensation costs. To the extent that ESOs are out of the money because of a decline in the economy, and not because of employee shirking, failure to reprice ESOs loads economy-wide risk

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onto employees. Employees will then need additional compensation to compensate them for bearing this risk.

Efficient contracting theory, competition for competent employees, and

share price volatility all predict the finding of a share price increase. Investors must feel that the expected incentive effects dominate investor concerns about opportunistic repricing, and that future firm performance will improve despite increased dilution and possible effects of poor corporate governance on future share returns. Yes, the finding supports efficient securities market theory. If the market is not reasonably efficient, share price would not quickly react positively to an event that is predicted to improve future firm performance on balance. This argument is strengthened by the finding that share price increased more when the employee retention and increased incentive reasons are more likely to hold. If markets are not reasonably efficient, share price would not rise, would rise with a lag, or would fall if the repricing was accompanied by negative media reaction. 15.

The reason seems to be that repricing increased the incentives of

executives to work hard relative to the effort incentives of executives of nonrepricing firms. b.

Economic incentives to reprice include: •

Extent of R&D. To the extent firms are in industries such as high tech, that are highly research intensive, competition for competent employees is high. Such firms also tend to include a high proportion of ESOs in compensation. To the extent that under-water ESOs reduce employees’ expected compensation utility below reservation level, they may leave the organization. To counter this, the firm may reprice its ESOs.

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• ESOs are intended to motivate longer-run managerial effort. Repricing restores, or at least increases, the value of ESOs to managers. This may increase the incentive of managers to exert longer-run effort, which could explain the finding of a 5-year improvement in profitability • Firm risk. The decline in share price leading up to repricing may indicate an increase in firm risk and resulting increased share price volatility. The greater the firm’s share price volatility, the greater the potential for ESOs to increase in value, other things equal. At the same time, the downside risk of ESOs is limited. Thus, the incentive effect of ESOs increases with firm risk, leading to increased economic benefits to the firm from repricing. • Extent to which ESOs are under water. The more are ESOs out of the money, the greater the negative effects on managers, hence the greater the economic benefits of repricing. c.

Reasons why no additional increase in operating performance was found

when repricing extended to all employees: • Non-executive employees may be too far down in the organization for them to perceive that increased effort on their part will lead to share price increase. • Other compensation components, such as salary and cash bonuses, are unlikely to increase when the firm is performing poorly. This may put a “brake” on effort motivation that cancels any increase in motivation resulting from repriced ESOs. 16.

Note: A general point that underlies these hypotheses is that a good performance measure should be highly informative about the manager’s effort in running the firm, and thus in generating investor payoff. This is accomplished through an efficient trade-off between sensitivity and precision. 396 .

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Noise. By definition, the less noise in net income (e.g., resulting from

a low firm risk environment, or higher quality reporting, which produces higher correlation between accounting and market returns) the more precisely net income captures the results of manager effort, other things equal. While individual non-financial measures may also reflect effort precisely, the less noise in net income the greater its efficiency relative to individual performance measures. Given that compensation committees want to maximize contract efficiency, Ittner, Larcker, and Rajan hypothesize that more noisy net income will have less relative weight in the compensation plan. (ii)

Firm Strategy. The reason for this hypothesis is that, for prospector

firms, it may take some time for the results of growth and innovation strategies to show up in net income. Yet to the extent the costs of such strategies, such as R&D, are written off as incurred under GAAP, nonfinancial performance measures are more sensitive to current manager effort than net income. For defender firms, cost savings and improvements in efficiency can be measured relatively quickly and accurately, and they affect net income with little lag. Consequently, net income is more highly correlated with current manager effort for such firms. Compensation committees of defender firms react by placing more weight on net income. (iii)

Product quality. Product quality is a characteristic that can be

measured quickly and accurately, for example by analyzing defect rates, returns, and warranty costs. Thus it provides a precise non-financial measure of employee effort devoted to quality. However, it may take some time for the effects of high quality products to show up in net income. One reason is that it may take some time for purchasers to realize that quality has improved, while costs of improving product quality are charged to expense as incurred. As a result, net income lags the non-financial performance measures. The greater the firm commitment to quality, the

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more it will use non-financial measures of product quality relative to net income as a quality incentive device. (iv)

Regulation. A major reason for regulation is that firms have a

monopoly in their product markets. The profits of regulated firms are limited by the regulatory process. This reduces sensitivity of net income as a performance measure. That is, even very high manager effort is constrained in its effect on the bottom line. However, by maintaining customer satisfaction with performance, courtesy, responsiveness, etc., the firm can help to sustain its monopoly position. As a result, non-financial performance measures such as these will be emphasized more strongly than net income in the compensation plans of such firms. b.

Firm strategy. The personal goals included in the RBC plan seem mostly

strategic in nature (e.g., development of U.S. operations). Thus RBC seems to regard itself as a prospector type firm. Since these strategies likely take some time to show up in net income, personal goal attainment is a more sensitive performance measure. To the extent that executives are directly responsible for product quality, courtesy, etc., the product quality hypothesis is also an explanation. Measures of product quality are likely sensitive to manager effort and measurable with reasonable precision, whereas with so many factors affecting net income, earnings may not be a precise measure of product quality performance.

17.

A company awards ESOs as compensation for the following efficient

contracting reasons: •

To lengthen the manager’s decision horizon. ESOs, being stockbased compensation, may motivate the manager to increase longerterm effort. Since an efficient stock market will look to the longer term expected payoffs of the manager’s actions, the manager’s compensation is not penalized for adopting longer-term projects that 398 .

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may reduce current net income, such as R&D and large capital investments. •

To control the length of the manager’s decision horizon. The firm may perceive economic benefits from lengthening this horizon. A high proportion of ESOs in the compensation contract, relative to net income-based compensation, encourages a longer run decision horizon.

•

To control the manager’s compensation risk. Since ESOs have relatively low downside risk and considerable upside risk, they encourage the manager to adopt risky projects. They also help to offset the downside risk imposed when compensation is based on (conditionally) conservative net income. Conservative net income imposes downside risk because unrealized losses are recognized in net income but unrealized gains are not.

•

To reduce cash compensation. Since ESOs do not require cash outlay, they provide effort motivation while conserving cash. This feature is of particular value to new companies, which may be short of cash.

•

To reduce compensation expense, enabling the firm to report higher net income. This reason no longer applies since accounting standards now require expensing of ESOs. However, it did apply during the period covered by UnitedHealth’s late timing activities.

Note: Some of the above reasons overlap. Also, to the extent that ESOs vest quickly, and managers are free to dispose of shares acquired, ESOs may induce a short decision horizon, resulting in opportunistic actions such as pump and dump, manipulation of share price, and other actions discussed in Section 8.6.

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Under the power theory, the CEO has sufficient power to influence the

Board of Directors and Compensation Committee. He/she uses this power to increase compensation above its reservation utility level. Late timing of ESO awards increases the recipient’s expected value of compensation because, in effect, ESOs are awarded in-the-money. c.

From the market model (Section 4.5.1, Equation 4.4), noting that αj = Rf (1-βj), the expected return on UnitedHealth’s shares for May 11 was: Expected return = 0.0001(1 – 0.4000) + 0.4000 × (-.0122) = 0.00006 - .00488 = -.00482 Actual return = -1.80/(1.80 + 44.37) = -1.80/46.17 = -.03899 Abnormal return was thus -.03899 + .00482 = -.03417, or -3.417%

Reasons why UnitedHealth’s share price fell on May 11: •

The whole market fell, pulling UnitedHealth shares down with it. However, this contributed to only part of the share price fall.

•

Revelation of late timing led the market to realize that the power theory of executive compensation was operating. That is, management was behaving opportunistically. Since this behaviour may well extend to other aspects of UnitedHealth’s operations, investors perceived an increase in estimation risk, causing share price to fall.

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The market feared the economic consequences of lower reported profits for 2003-2005. These include possible violation of debt covenants, possible dysfunctional manager actions resulting from corrections of late timing awards, and manager departures.

•

The market anticipated lawsuits and fines against UnitedHealth as a result of the late timing, despite the company’s claim that cash flows would not be affected.

•

If markets are not fully efficient, share price could have fallen due to the estimated reductions in reported net income for 2003-2005. Nonrational investors may not realize that these reductions do not directly affect future cash flows.

Under APB 25, an expense had to be recorded for any amounts that ESO

awards are in the money, that is, for the intrinsic value of the ESOs (see Section 8.6). This expense was disguised by the late timing. Correction of the late timing results in a retroactive adjustment to record the intrinsic value as compensation expense. This amount is the difference between the original exercise price of the ESOs and underlying share value on the actual grant date. In HealthSouth’s case, the increase in compensation expense would be even higher since the share value was reset to its highest price during the year of award, not the share price on the actual award date. f.

Late timing increases the likelihood that the ESO will be deep-in-the money.

According to the analysis of Huddart (1994), deep-in-the-money ESOs are more likely to be exercised early (Section 8.6). Consequently, the firm may need to shorten its estimate of time to exercise in the Black/Scholes formula. g.

Other ways to manipulate the value of ESO awards: •

Release BN shortly before the ESO grant date, for scheduled awards. This forces share price down, thus lowering ESO exercise price (see Section 8.6). 401 .

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Manipulate the award date, for non-scheduled ESO awards, particularly if the power theory applies. The date may be manipulated to just before GN is released (spring loading--see Section 8.6).

•

Pump and dump. When exercise date arrives, pump up share price to increase ESO value. Exercise the ESOs and then sell the shares acquired before their market price falls post-pumping.

•

Manipulate the share price variability input into the Black/Scholes formula. Lower variability produces a lower estimate of ESO fair value (see Section 7.9.1). Lower fair value, hence lower compensation expense under current accounting standards, may encourage the compensation committee to award more ESOs.

18.

In theory, awarding shares and ESOs as compensation should give

management a longer-run decision horizon, since compensation based on share performance is less affected than net income-based compensation by actions that may lower reported earnings in the short run (e.g., R&D) but which promise longerterm payoffs. A longer-run decision horizon should also discourage the type of short-run, opportunistic, behaviour charged, since the discovery of such behaviour will lower share price. b.

The theory broke down in this instance since Kmart management

compromised their longer-run interests by adopting very short-run dysfunctional behaviour, attempting to disguise the reasons for the firm’s liquidity crunch, possibly in the belief that if they could successfully get through their short-run liquidity problems and pay off their suppliers, little harm would have been done, including to share price. As it turned out, the longer run payoffs of these actions were negative, since Kmart declared bankruptcy in 2002. Also, awarding company shares and ESOs can produce effects on manager decision horizons opposite to those intended. For example, management’s behaviour could have been driven by a “pump and dump” motive. That is, management realized the firm was in serious difficulties so they attempted to 402 .

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maintain share price long enough to exercise ESOs and dispose of shares at inflated values. It thus seems that, in practice, the awarding of shares and ESOs is not completely effective in motivating longer-run behaviour. A non-opportunistic alternative strategy would have been for management to candidly discuss the real reasons for the solvency problem and their plans to work out of it. While this may or may not have prevented bankruptcy, it would have reduced the damage to management’s reputation and possibly reduced or avoided the subsequent SEC charges. 19.

If shareholders have information about executive compensation, such as

amounts and types of compensation, they can relate this pay package to share price performance and can thus make informed decisions on whether the executives are overpaid in relation to their performance. If they feel these are out of line, they can bring pressure on the firm to change the compensation contract. This is particularly so if shareholders have a say on pay. Alternatively, or in addition, they can bid down the firm’s share price.

With respect to risk, If the manager earns high compensation because the firm has adopted very risky strategies which have paid off, investors should be aware of this, since future risky strategies may not be so fortunate. This supports the disclosure of the relationship between compensation and risk management. b.

Awarding incentive compensation in the form of ESOs and/or restricted

stock is intended to give senior executives a longer-term decision horizon. A longerterm horizon discourages short-term, opportunistic actions that are dysfunctional towards the firm’s longer-term interests, such as cutting maintenance, cutting R&D, or manufacturing for stock so as to bury overhead costs in inventory. Managers who hold company options and/or shares will realize that the market will punish the

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firm’s share price upon becoming aware of such actions, thereby lowering the value of their holdings. c.

Yes. If executive pay is too dependent on longer-term incentives, the

executive will bear considerable non-diversifiable compensation risk, particularly if the performance measure is low in precision (that is, highly affected by factors that the manager feels are not informative about his/her effort in generating future payoffs). Then, to maintain reservation utility, the manager may demand higher expected pay to compensate for the greater risk, or change operating policies. Operating policy reactions to excessive compensation risk include adoption of strategies that involve relatively safe returns, and/or excessive hedging. For example, a manager may choose to drill for oil and gas in western Canada rather than in offshore, politically unstable, or arctic regions. Such actions are not necessarily in the best interests of the firm and its (diversified) shareholders. However, if share-based compensation is in the form of ESOs, which have limited downside risk, the manager may adopt very risky operating policies, since he/she has everything to gain and little to lose. Some balance between these two types of longer-term incentives seems desirable. Also, there are times when a short run decision horizon is in the firm’s best interests, such as a need to cut costs or conserve cash. Longer-term decision horizons may work against these policies. Some balance between ESOs and shortterm incentive awards is desirable. Finally, if vesting periods are short and the manager is free to dispose of shares acquired, ESOs can generate incentives to opportunistically increase share price in the short run (Section 8.6), the opposite of the longer-run decision horizon they are intended to create. d.

A well- working managerial labour market is one in which the manager’s

market value (equivalently, the reservation utility he/she can command), reasonably reflects the manager’s ability. 404 .

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The compensation disclosure requirements add to the stock of publicly available information about managers (otherwise, why introduce them?). This information includes the types and amounts of compensation, the compensation committee’s evaluation of the manager’s ability and performance, and additional information about risk management so that investors can evaluate the manager’s compensation relative to the riskiness of his/her operating policies.. Then, the ability of the market to evaluate manager ability, compare compensation cost to the value of the manager’s services, and the extent to which the manager may engage in opportunistic behaviour is improved. That is, the market works better. However, to the extent the power theory of executive compensation holds, the effectiveness of these disclosure requirements will be reduced, since the manager may have enough power in the organization to attain excessive compensation anyway. Note that the power theory includes tactics whereby the CEO may do this, namely camouflage to disguise excessive compensation and reduce public outrage. A reasonable conclusion is that the disclosure requirements will improve the working of the managerial labour market, since they increase publicly available information about manager ability, performance, and risk, and make it more difficult for the manager to attain excessive compensation. The findings of Lo (2003) are consistent with this conclusion. e.

Yes. Under labour market efficiency, the manager’s market value reflects

only publicly available information. To the extent this information is incomplete or biased, we cannot completely rely on managerial labour market forces to provide incentives for managers to work hard. One reason is moral hazard, leading to earnings management to cover up shirking. While the disclosure requirements may assist the managerial labour market to work well, it is unlikely that they will enable full public knowledge of the manager’s 405 .

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fundamental value. One reason is that the requirements say nothing about earnings management—controlling this is the responsibility of the accountant/auditor and GAAP. The disclosure requirements do include a “detailed explanation” of the compensation of the five highest-paid firm executives and a report from the compensation committee justifying the pay levels. Also, disclosures of the relationship between compensation and risk are required. However, these requirements are quite general and subjective and do not guarantee that every relevant aspect of manager performance will be taken into account or disclosed (consider, for example, evidence that compensation committees are less likely to penalize the manager for non-recurring losses than to reward them for nonrecurring gains). Then, market forces of competition are hampered in their ability to drive compensation to a level that reflects the manager’s fundamental value. Consequently, incentive plans are still needed. This conclusion is reinforced by the empirical results of Wolfson (1985) (admittedly, in a small sample from only one industry) and Bushman, Engel, and Smith, (2006), who found that while market forces reduce the need for an incentive contract, they do not eliminate it. 20.

Whether say on pay is an advantage or disadvantage depends on which

model of executive compensation is most descriptive of reality. If managerial labour markets are reasonably efficient, managers receive their reservation utility. If so, any reduction in utility of compensation as compensation committees anticipate or react to shareholder say on pay concerns may lead to managers leaving the firm or adopting less risky operating strategies. This harms both the firm and its (diversified) shareholders. To the extent managerial markets are not fully efficient, the power theory may hold. Then, say on pay is an advantage if it reduces manager excess compensation. As the Royal Dutch Shell case illustrates, even if say on pay is non-binding, compensation committees may hesitate to proceed against shareholders’ expressed concerns.

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No. manager compensation contracts involve a delicate mix of incentive,

risk, and decision horizon considerations. It would be difficult for shareholders who are not expert in the theory of executive compensation to efficiently balance these compensation components. Shareholders may instead react negatively to high absolute amounts of manager compensation, without realizing matters such as RPE, which may result in bonuses even if targets are not achieved when the manager’s performance exceeds that of a peer group, and the huge size of some companies that makes compensation that is small relative to value created also look huge.. Shareholders may not appreciate the impact of effort aversion and compensation risk on manager pay. There is evidence that much of compensation constitutes a valid reimbursement for effort aversion and risk borne by the manager. Also, the manager’s compensation is less than it seems at first glance, since bonus deferrals, deferred stock, and lack of ability to diversify ESO and stock holdings reduce his/her compensation utility relative to its cost to the company. The result of binding say on pay would be to severely disrupt manager performance and the managerial labour market. 21.

The effect of SOX on CFO reservation utilities was to lower their reservation

utilities if IC quality was low, and increase their reservation utilities if IC quality was high. Assuming efficient contracting, the level of compensation is positively related to reservation utility. A compensation decline in low IC quality firm CFO compensation post SOX thus implies lower CFO reservation utility, and vice versa for high IC quality CFOs. b.

The finding of higher executive bonus post SOX for low IC quality firms pre

SOX implies an increase in the informativeness of net income about executive effort. Executive bonuses depend primarily on net income. Since SOX requires reporting not only the existence of an IC weakness but also its remediation, CFOs of weak IC firms have a strong motivation to correct the weakness. This improves 407 .

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the quality of the firm’s financial reporting, making it more difficult for executives to shirk and opportunistically disguise shirking by manipulation of reported earnings. Less shirking means greater executive effort and higher earnings (ROA). Compensation committees respond with higher bonuses.. Note: This argument is supported by the finding that higher executive bonus was not found for high IC quality firms. Since such firms reported no IC deficiencies, there is less incentive to further improve financial reporting quality. This finding also implies sophisticated use of accounting information by compensation committees. Since other compensation components than bonus did not increase, this suggests an increase in the relative importance of net income in compensation. This is just what is predicted by contract and agency theory when the informativeness of a performance measure increases. c.

Yes, the operation of the managerial labour market for CFOs appears to

have improved post SOX. The moral hazard problem has been reduced since it is more difficult for CFOs to opportunistically disguise low effort (in this case, low effort exerted towards internal controls over financial reporting quality) by manipulation of reported earnings. As a result, the compensation of CFOs and other managers better reflects the quality of their effort. The greater likelihood of low-quality CFOs being fired supports this argument. d.

The proper operation of the managerial labour market is important for a

market-oriented economy because the success of such an economy depends on the quality of managerial effort as much as it depends on the proper operation of security markets. Due to moral hazard, managers may shirk on effort. However, if the market value of a manager (i.e., reservation utility) reflects performance, managers who do not shirk on efort and, as a result, generate increased firm performance, are rewarded. Those who do not perform are motivated to increase effort and firm performance. As a result, the economy becomes more productive, thereby increasing social welfare.

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A criticism often made against ESO compensation is that ESOs encourage

excessive manager risk taking, since he/she has everything to gain and little to lose. Paying bonus in company bonds reduces the incentive to take risks since, unlike for ESOs, there is little effect on the value of bonds if the risky strategies pay off. However, the incentive for UBS senior managers to adopt only safe operating strategies, which would not be desired by diversified investors, is not eliminated since only 40 % of bonuses are paid in bonds. b.

The UBS bonus plan would encourage adoption of conditionally

conservative accounting policies. Such policies are designed primarily to protect debtholders through preventing payment of excessive dividends and preventing managers from receiving excessive earnings-based bonus compensation when earnings are inflated through unrealized gains. To the extent the manager is a debtholder, he/she does not receive dividends, and does not receive earningsbased bonus compensation. Consequently, there is less negative effect of conditional conservatism on the manager. Indeed, to the extent that conditional conservatism increases the probability that the firm survives, the manager will benefit from such policies through increased debt security (but lower interest rates). c.

It is unlikely that the manager’s temptation to shirk and cover up through

opportunistic earnings management would be affected. This temptation remains in the presence of bonus paid in debt. One reason is that the manager’s concern about reputation would still continue, regardless of how bonus is paid. Also, to the extent that bonus is not entirely paid in bonds, bonus paid in stock-based compensation would also continue to encourage opportunistic earnings management. Note: An argument that shirking would be encouraged because the value of company bonds is less affected than the value of ESOs and shares when lower net income is reported is equally acceptable. It there is greater manager shirking, this will likely result in more opportunistic earnings management to cover up. 409 .

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Additional Problems 10A-1 Following major declines in their share prices, firms frequently reprice outstanding stock options issued to executives and employees as part of their incentive compensation. Reproduced here is an article from The Financial Post (April 3, 1997), describing such a repricing by Rogers Communications Inc. According to the article, Rogers’ stock options with exercise prices ranging from $12.64 to $19.38 were lowered to an exercise price of $8.31. ROGERS REPRICES COMPENSATION OPTIONS Rogers Communications Inc. repriced all the options its executives and other employees have received as part of their compensation packages in 1994 and 1995 because the company’s share price has fallen so far, Rogers’ annual shareholder circular says. The options’ new exercise price is $8.31, significantly lower than the earlier prices, said Rogers’ spokeswoman Jan Innes. Previously, exercise prices ranged from $12.64 to $19.38. Also, the exercise period was extended to 2006. “If you’ve got options and they’re well above what the stock is trading at, they’re certainly not very interesting,” explained Jan Innes. Rogers’ circular says the company awards options to “focus executives’ attention on the long-term interests of the corporation and its shareholders.” Analysts were surprised by the move. “I can imagine that shareholders will be a bit perturbed,” said one. “After all, their shares didn’t get repriced. But I suppose it will help keep people motivated.”

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Roger’s shares have fallen drastically since 1993, when they hit a $21.88 high. The shares (RCIb/TSE) closed yesterday at $8, down 55¢. Ted Rogers’ options, along with other non-management directors’ options, will not be repriced. Rogers’ class A shareholders, the only ones entitled to vote, will vote on the arrangement at the company’s annual meeting May 2. Ted Rogers controls over 90% of the A shares, so the vote should pass. Meanwhile, working two jobs is paying off for Ted Rogers, president and chief executive of Rogers Communications and acting president of Rogers Cablesystems Ltd. Rogers got a 21% salary increase to $600,000 for 1996, plus a 160% rise in his bonus, to $260,110, for a total of $860,110. In addition, he was given 300,000 new options. But he was not the highest paid executive at the cable and telecommunications company he founded. That distinction went to Stan Kabala, chief operating officer of telecommunications and chief executive of Rogers Cantel Mobile Communications Inc. Kabala, who joined Rogers Jan. 1, 1996, got a salary of $600,000, plus a bonus of $925,000, for a total of $1,525,000. He was also awarded 119,000 stock options. Kabala’s big bonus was related to a deal completed in November 1996 with U.S. phone giant AT&T Corp., as well as for Cantel’s performance. The last time Rogers paid bonuses of such magnitude was in 1994 after it completed its takeover of Maclean Hunter Ltd. SOURCE: The National Post, April 3, 1997. Reprinted by permission. Required 411 .

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Give reasons why firms frequently issue stock options to executives and

senior employees as part of their incentive compensation. b.

If options are always repriced when share prices fall, regardless of the

reason for the fall, what effects may there be on the incentives to work hard of officers and employees involved? c.

If you were a shareholder of Rogers Communications, how would you react

to the repricing? d.

It has been argued that options held by the CEO should not be repriced,

even if repricing is extended to less senior executives and employees. Note that the article reports that options held by Ted Rogers, president and CEO of Rogers Communications, are not being repriced. Why?

10A-2 Refer to Theory in Practice 10.3 in Section 10.6 concerning BCE Inc. Reproduced below are the 1997 consolidated statement of operations and Note 2 to the financial statements of BCE. The statement of operations shows an extraordinary charge of $2.950 billion for stranded costs. After this extraordinary charge, operations showed a net loss for the year of $1.536 billion. Required a.

Would you support exclusion of the charge from earnings for the purpose of

managers’ short-term incentive awards? Discuss. b.

What is the persistence of the $2.950 billion component of 1997 earnings?

Your answer should be in the range [0–1]. Explain your answer. c.

On April 23, 1998, The Globe and Mail reported “Earnings results fuel BCE

shares to 52-week high.” This headline refers to BCE’s record reported earnings for its first quarter, 1998, of 48 cents per share excluding “onetime items.” This is a 46% increase over 33 cents per share for the same quarter of 1997. The article 412 .

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quoted the CEO of BCE as saying, “We continue to see solid growth in all areas of our operations.” According to the article, these first-quarter results suggest a good performance by BCE in 1998, after a $1.5 billion loss in 1997 due to a record $2.9 billion charge at its telephone company subsidiary. Give another reason, in addition to “solid growth,” that may explain the record firstquarter results. As a member of the BCE compensation committee contemplating the 1998 annual short-term incentive awards, would you support basing these awards on the record first-quarter earnings? Explain your position. Consolidated Financial Statements—BCE Inc. Consolidated Statement of Operations ($ million, except per share amounts) For the years ended December 31

1997

1996

1995

Revenues

33,191

28,167

24,624

Operating expenses

25,795

22,011

19,434

Research and development expense

2,911

2,471

2,134

Operating profit

4,485

3,685

3,056

Other income

365

393

238

Operating earnings

4,850

4,078

3,294

Interest expense

1,111

1,160

1,154

121

141

172

1,232

1,301

1,326

2,777

1,968

– long-term debt – other debt

Total interest expense

Earnings before taxes, non-controlling interest and extraordinary item

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(1,522)

(1,118)

(819)

Non-controlling interest

(682)

(507)

(367)

Net earnings before extraordinary item

1,414

1,152

782

Extraordinary item

(2,950)

—

Net earnings (loss)

(1,536)

1,152

782

(74)

(76)

(87)

(1,610)

1,076

695

Net earnings before extraordinary item

2.11

1.70

1.12

Extraordinary item

(4.64)

—

Net earnings (loss)

(2.53)

1.70

1.12

Dividends per common share1

1.36

636.0

632.7

622.9

Dividends on preferred shares Net earnings (loss) applicable to common shares Earnings (loss) per common share1

Average number of common shares 1

outstanding (millions) 1

Reflects the subdivision of common shares on a two-for-one basis on May 14, 1997. Extraordinary Item As at December 31, 1997, BCE determined that most of its telecommunications subsidiary and associated companies no longer met the criteria necessary for the continued application of regulatory accounting provisions. As a result, BCE recorded an extraordinary non-cash charge of $2,950 million, net of an income tax benefit of $1,892 million and a non-controlling interest of $38 million. Also included in the extraordinary item is an after-tax charge of $97 million representing BCE’s share of the related extraordinary item of its associated companies. 414 .

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The operations of most of BCE’s telecommunications subsidiary and associated companies no longer met the criteria for application of regulatory accounting provisions due to significant changes in regulation including the implementation of price cap regulation which replaced rate-of-return regulation effective January 1, 1998, and the concurrent introduction of competition in the local exchange market. Accordingly, BCE adjusted the net carrying values of assets and liabilities as at December 31, 1997, to reflect values appropriate under GAAP for enterprises no longer subject to rate-of-return regulation. The determination by BCE that most of its telecommunications subsidiary and associated companies no longer met the criteria for the continuing application of regulatory accounting provisions is the result of a review, which began in 1997, to assess the impact of the introduction of price cap regulation coupled with the introduction of competition in the local exchange market. Before the advent of these two factors, accounting practices were based on a regulatory regime which provided reasonable assurance of the recovery of costs through rates set by the regulator and charged to customers. These regulatory accounting provisions resulted in the recognition of certain assets and liabilities along with capital asset lives which were substantially different from enterprises not subject to rate-of-return regulation. The extraordinary charge consists of a pre-tax charge of $3,602 million related to capital assets and a pre-tax charge of $1,181 million to adjust the carrying values of other assets and liabilities to arrive at carrying values appropriate for enterprises not subject to rate-of-return regulation. The amount of the charge related to capital assets was determined based upon an estimate of the underlying cash flows using management’s best estimate assumptions concerning the most likely course of action and other factors relating to competition, technological changes and the evolution of products and services. The net carrying values of capital assets were adjusted primarily through an increase in accumulated depreciation. The primary component of the $1,181 million charge relates to the write-off of deferred business transformation and workforce reduction costs. 415 .

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Source: BCE Inc., 1997 annual report. Reprinted by permission. 10A-3 Many firms “reprice” ESOs following major declines in their share price by lowering the exercise price. This is because ESOs issued before the decline are deep out of the money, hence unlikely to be of any value. Such moves usually outrage shareholders, who have seen the value of their shares also fall but who receive no comparable benefits, and are prominently reported in the media. Saly (1994) did an original analytical study of the repricing of ESOs. Her analysis applies to repricing after a market downturn, such as the downturn experienced in the early 2000s, and not to a firm-specific fall in share price that may be due to manager shirking. As Saly points out, compensation contracts are incomplete. That is, it is unlikely that provisions for adjustments to compensation following a market downturn are anticipated and written into the compensation plan. The question then is, should the contract be “renegotiated” following a market downturn by repricing ESOs? If so, this would violate a general rule that, once signed, contracts tend to be rigid. In Saly’s model, the answer is yes. Renegotiation of the ESOs’ strike price increases the correlation between manager effort and the performance measure (share price), since a market downturn is not a result of low manager effort. Without the possibility of renegotiation, the risk-averse manager would have to be compensated for the risk inherent in the possibility of a market downturn if he/she is to attain reservation utility. If a downturn occurs and there is no repricing, the manager’s expected utility of compensation will fall, since the expected proceeds from ESOs are effectively zero. This will cause him/her to either shirk or leave the company. In June 2001, Nortel Networks Corp. announced that it was cancelling its existing ESOs and replacing them with new ESOs with a lower strike price. Nortel’s share price, which had been in excess of $100 when many of the ESOs were issued, suffered following the market collapse of share prices of high-tech firms, and was trading in the $20 range at the time of the announcement. Nortel’s move was widely 416 .

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reported in the financial media and drew significant negative comment. For example, The Globe and Mail (June 5, 2001) quoted Carol Bowie of the Investor Responsibility Research Center as saying “... you can’t make the 50-yard kick. So we’ll cut it down to 35.” It also quoted J. Richard Finlay, head of the Centre for Corporate and Public Governance, as saying “We’d all like to be told our high school physics test where we got 35 out of 100 is now 35 out of 50, but shareholders don’t have that luxury.” Nortel defended its move by claiming it was necessary to retain key employees, pointing out that top manager ESOs were not being repriced (this would require shareholder approval) but only those of lower level employees. In the same issue of the Globe, Brian Milner pointed out that the cost to Nortel of repricing the ESOs is zero, and that no further dilution of shareholders’ equity will result since the old ESOs are being cancelled. Nevertheless, Milner comments that in the public eye the repricing is still “a reward for crummy performance.” Required a.

In the light of Saly’s model, do you agree with Nortel’s ESO repricing?

Explain why or why not. b.

Nortel planned to cancel existing ESOs and replace them with new ones,

rather than simply repricing the existing options to a lower exercise price. Recall that in 2001, GAAP did not require expensing of ESOs. Rather, most firms, including Nortel, followed APB 25 (see Section 8.6) in the financial statements proper. Why do you think Nortel replaced the old ESOs with new ones, rather than simply repricing the existing ones? c.

In its 2003 proxy statement, the Compensation Committee of General

Electric Company reported that the company has a policy of not repricing ESOs. Why would a company have such a policy?

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Suggested Solutions to Additional Problems 10A-1 a.

Some reasons why firms issue options as executive and senior employee

compensation are: •

Managers with a short-term decision horizon may engage in short-run income maximization if the incentive plan is based only on reported net income. Options are intended to lengthen the manager’s decision horizon, thereby reducing the incentive to engage in this behaviour.

Note: To the extent that options encourage “pump and dump” and other types of opportunistic ESO behaviour, the force of this argument is reduced. •

Options do not require cash, unlike salaries or bonuses. This can be particularly attractive to rapidly growing firms and firms that extend option grants to all employees.

•

At the time of the article, ESOs were typically not recorded as an expense, thereby improving the bottom line. While this may not have mattered under efficient securities market theory (assuming he market is aware of the details of ESO awards), it does matter under contracting theory, due to contract rigidity and resulting impacts on the probability of violation of debt contracts.

Note: The preceeding argument no longer applies since GAAP now requires ESO expensing. •

By reducing downside compensation risk, options may enable more efficient compensation contracts by providing managers with incentives to engage in risky projects. This incentive can go too far, however, and encourage managers to take on too much risk.

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Employees will work less hard because if their shirking leads to a drop in

share price below exercise price, they expect to be bailed out by option repricing. c.

As a shareholder, you may object if you feel that the officers and employees

of Rogers are “off-the-hook” for the decline in share price while you are not. This raises ethical issues of fairness. Also, from b, the repricing may lead to reduced employee effort in future if employees feel they will always be bailed out. The lower exercise price will further dilute the equity of existing shareholders, leading to a further fall in market value of Rogers’ shares. You may not object, however, if the repricing leads talented and motivated employees to stay with the firm, since the fall in value of their options may have reduced their expected utilities below reservation level. This could cause senior people to leave the firm, possibly leading to a further decline in share price. Even if employees do not leave, if there is little likelihood that their ESOs will ever be worth anything, their incentive to exert effort falls, so that they may shirk. Of course, if the reason the options are underwater in the first place is shirking, they should leave since it is likely they will continue to shirk after repricing. Another reason not to object is that the fall in share price may be due to economywide effects, or to securities market inefficiencies leading to the bursting of a bubble. Then, you may feel that the share price decline is not really the employees’ fault. d.

Ultimately, it is the CEO who is most responsible for the fall in stock price.

Consequently, the arguments against repricing in parts b and c apply with special force to the CEO. Note: Repricing is an example of contract incompleteness. If the fall in share price had been anticipated, provisions to deal with it could have been incorporated into the compensation contract. Without such provisions, the media attention to 419 .

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repricing reinforces contract rigidity, since the firm knows that if it changes the original contract provisions by repricing it will receive adverse publicity.

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10A-2 a.

If it is accepted that the charge is not management’s “fault,” (i.e., low

informativeness with respect to manager effort) then it seems reasonable to support exclusion for purposes of BCE’s short-term incentive awards. If the charge is deemed to be within management’s responsibility and is informative about management effort, this would support inclusion. Note: Exclusion would also be supported to the extent that the change in regulatory environment reduced BCE’s share price. Assuming that, like most large public firms, management holds a considerable number of shares, both directly, and indirectly as options and share units, management should not be penalized twice. This could induce dysfunctional behaviour. b.

Persistence is 1, assuming that the estimated $2.950 billion cost of the

stranded costs is accurate. While the losses leading to the extraordinary charge are not yet realized (i.e., the charge is an accrual), they do seem to have been validly incurred, since the deregulation event that lead to the losses has actually taken place, on January 1, 1998, according to Note 2. However, these charges are unlikely to recur. In Ramakrishnan and Thomas’ (1991) terms (Section 5.4.1), they are transitory, with an ERC of 1. That is, since there is a real loss to BCE, the firm’s market value, assuming market efficiency, will fall by that amount, other things equal. c.

Another reason for the record first quarter results is that the $2.95 billion

1997 writeoff reduced future charges for amortization, and created reserve accounts to absorb costs that might otherwise be charged to expense in 1998. In effect, the effect of the writedown will be to raise future years’ reported earnings by $2.95 billion relative to what they would be without the charge. As a member of the compensation committee, an argument for not basing shortterm incentive awards for 1998 on the record profits is that a portion of these profits arose from reduced amortization and other expenses resulting from the 1997 421 .

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writedown. This portion of profits should be excluded from 1998 earnings for bonus purposes because it is not informative about 1998 management effort. This argument is strengthened since the 1997 write-down was excluded for bonus purposes in 1997 (Theory in Practice 10.3). If 1998 profits for bonus purposes are not reduced, management would benefit both ways. That is, if management was not penalized for the 1997 charge, it should not be rewarded for the increased reported earnings in future periods that result from the charge. Assuming management knew that they would not be penalized for the 1997 writedown but rewarded on the basis of the full amount of subsequent reported profits, management has a temptation to overstate the 1997 write-down. The possibility of such overstatement further supports reducing 1898 profits for bonus purposes. However, counterarguments can be made, especially if it is felt that the stranded costs were not management’s responsibility. In effect, the 1998 write-down “clears the decks.” Management should be evaluated for bonus purposes with respect to the new environment, and not penalized for ghosts of the past. That is, if BCEs assets after the write-down properly measured their fair values after deregulation, then management compensation should be based on net income that reflects these lower fair values. 10A-3 a.

The collapse of share prices of high-tech firms suggests that economy-wide

events were responsible for the drastic decline in Nortel’s share price. This suggestion is reinforced by behavioural finance, which suggests that share prices are subject to momentum and bubble effects, which can lead to a sudden collapse of share prices. Thus, it does not seem that shirking by Nortel employees was the cause of Nortel’s share price collapse. Then, Saly’s analysis supports repricing since, without it, employees may leave the organization. Furthermore, according to Saly, without the possibility of renegotiation (repricing is a form of renegotiation) following a major share price decline, risk-averse employees would have to be compensated ex ante for this risk in order to attain their reservation utility. In effect, 422 .

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they will demand higher compensation if they expect to bear the risk of an economy-wide collapse themselves. b.

Under APB 25, an expense had to be recorded to the extent that the

exercise price of an employee option was less than share price when the options were granted. If the existing options were repriced downwards, the new exercise price would be less than share price at the time they were granted. This would trigger the recording of an expense under APB 25. If the options were cancelled and replaced with new ones with an exercise price not less than the current Nortel share price (more precisely, the share price on the date the new options were granted), no expense would be recognized under APB 25. Since the effect on employee effort and retention is the same either way, Nortel preferred to avoid recording an expense. c.

Reasons why GE would have a policy of not repricing ESOs include: •

To avoid the strong media and investor criticism that follows repricing. This could trigger shareholder backlash, such as a fall in share price because of investors selling their shares, and difficulty in selling any new share issues. It could also result in political costs, such as new and expanded compensation disclosure regulations, arising from the adverse media attention.

•

GE may have had other components in its compensation plan, such as restricted stock and/or bonuses, that could be adjusted to maintain the reservation utility of key employees. This could be less costly than the costs of investor backlash.

•

GE may have been unaware of Saly’s argument that when ESOs are not repriced, employees must bear the cost of underwater ESOs. To the extent ESOs go underwater due to economy-wide events, employees’ anticipation of the risk resulting from this possibility leads them to demand higher expected compensation. 423 .

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GE may have been aware of Saly’s argument but felt that if its ESOs go underwater the reason is likely to be manager shirking rather than economy-wide events. If employees felt that they would likely be bailed out for the adverse effects of shirking on share price, effort would be adversely affected since awareness of likely repricing reduces employee compensation risk, and employees must bear risk to motivate effort.

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CHAPTER 11 EARNINGS MANAGEMENT 11.1

Overview

11.2

Patterns of Earnings Management

11.3

Evidence of Earnings Management for Bonus Purposes

11.4

Other Motivations for Earnings Management 11.4.1 Other Contracting Motivations 11.4.2 To Meet Investors’ Earnings Expectations and Maintain Reputation 11.4.3 Initial Public Offerings

11.5

The Good Side of Earnings Management 11.5.1 Blocked Communicaton 11.5.2 Empirical Evidence of Good Earnings Management

11.6

The Bad Side of Earnings Management 11.6.1 Opportunistic Earnings Management 11.6.2 Do Managers Accept Securities Market Efficiency? 11.6.3 Analyzing Managers’ Speech to Detect Earnings Management 11.6.4 Implications for Accountants

11.7

Conclusions on Earnings Management

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LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

To Outline Reasons for Earnings Management

I recommend introducing students to the topic of earnings management by discussing Healy’s seminal 1985 bonus plan paper. Healy’s evidence that bonus plans motivate earnings management helps students to take contracting theory seriously. It opens up a whole new set of considerations in accounting policy choice beyond the disclosure of useful information to investors. I sometimes ask the question whether management would admit to the behaviour documented by Healy, and whether the auditor would assist or oppose the manager in this type of earnings management. For those interested in research methodology, Healy’s paper can be used to point out the desirability in accounting research areas such as this of using empirical analysis of hard data, with good experimental design and statistical analysis, in order to more fully understand management’s accounting policy choices. Having said this, it is important that the Healy results not be “oversold,” since Healy faced substantial methodological problems, particularly with respect to separating discretionary and non-discretionary accruals. The text contains discussions of some of these problems, and the results of some subsequent papers, in Section 11.3. The Jones’ (1991) methodology which, with some variants, is still the state of the art in estimating discretionary accruals is reviewed in Section 11.3. I do not spend much class time on these methodological issues, other than a brief review of the Holthausen, Larcker and Sloan (1995) paper. This paper, with better data and different methodology, supports Healy’s results for firms with above-cap earnings, even though Healy’s below-bogey results seem to disappear in their study. Since it now appears that meeting earnings expectations drove at least some of the financial reporting scandals of the early 2000s, such as WorldCom, I also suggest class discussion of the material in Section 11.4.2. This sets up the interrelation between investor-oriented and contracting rationales for earnings management.

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To Appreciate the Good Side of Earnings Management

I begin by asking if the earnings management behaviour documented by Healy is good or bad. I usually take the role of arguing it is good, from an efficient contracting perspective. This argument is strengthened if the earnings management was anticipated by the principal when the bonus contract was being negotiated, so that it is allowed for in setting the bonus rate. If it was, the manager might as well engage in earnings management since he/she is paying for it in the contract. While most people probably view earnings management with suspicion, I suggest 2 good sides. One, as just mentioned, is to lower contracting costs in the face of rigid and incomplete contracts. A second, and more controversial, side is that earnings management can reveal inside information to investors. A provocative discussion question here is to ask if earnings management can be thought of as an extension of the accrual process. That is, if accruals smooth out lumpy cash flows to produce a more useful measure of quarterly and annual performance, why can’t earnings management be used to smooth out annual accrual-based earnings to produce a more useful multi-year measure of persistent earning power? Such a measure may help investors better predict future firm performance, which is a major goal of financial reporting. To pursue the argument that earnings management as a vehicle to release inside information can be “good,” the case of General Electric Co. (Problem 8 of this chapter) works well to get the point across. The steady increase in GE’s reported earnings over the years is quite impressive. I point out the complexity of GE to the point where even financial analysts have difficulty in understanding the whole company. As a result, it is very difficult to estimate GE’s persistent earning power. I also point out that a simple announcement by GE of its persistent future earnings is ‘blocked.” Such an announcement lacks credibility since, for such a complex company, the market has little ability to verify it. This sets up the role of “good” earnings management as a credible way to reveal this information. An argument that GE does engage in earnings management for this purpose” is supported by both the variety 427 .

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of earnings management devices available to it and the steadily increasing pattern of its earnings over time. It is interesting to note that GE’s earnings management came under suspicion in the market in the early 2000s, due to the severe apprehension of post-Enron investors about earnings management in general. According to an article “General Electric: Big game hunting” in The Economist (March 14, 2002) investors may have interpreted GE’s increased reported earnings for 2001 as evidence of bad earnings management, since poor economic conditions during 2001 suggest that earnings should have declined. In addition, GE appointed a new CEO in late 2001. The Economist suggests that the market may have less trust in the new CEO than in Jack Welch, the highly regarded former CEO, simply because he is less of a known quantity. As a result, the market may have felt that there is a higher likelihood that GE will use its considerable potential for earnings management for bad purposes rather than good. GE’s response to these market concerns is worth noting. It started to release considerably more information. Discussion of how GE worked to overcome investor scepticism is given in Theory in Practice 12.1 Problem 19 of Chapter 12. Discussion of market reaction to GE’s lower reported earnings during the 2007-2008 market meltdowns is given in Problem 9 of this chapter. 3.

To Appreciate the Bad Side of Earnings Management

Despite the above arguments, most people would likely regard earnings management with suspicion, reinforced by revelation of serious abuses of earnings management by Enron and WorldCom and numerous other corporations in the early 2000s. Consequently, students should not be left with the impression that it is necessarily good. A useful place to start is Hanna’s 1999 article in CA Magazine, which is still well worth assigning and discussing, even though the rules surrounding reporting of unusual items have changed since the article was written. The important point to get across from this article is that management is tempted to provide excessive unusual, non-recurring and extraordinary charges, to put future earnings in the bank. Furthermore, these future earnings are buried in operations. This makes it difficult for investors to diagnose the reasons for subsequent earnings increases. Nortel Networks’ 428 .

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reversals of its excess accruals (see Problem 11.12) provide a vivid example of Hanna’s argument. Also, the effect on future profits of putting earnings in the bank has been recognized by an article in The Economist (“A world awash with profits, Business is booming almost everywhere,” February 18, 2005, pp. 62-63). This article states that one reason for the dramatic increase in firm profits during 2002-2004 is that they are an “accounting fiction,” which apparently means that they are a consequence of earlier writeoffs. I find that to drive home these various considerations, an example of how earnings management can go too far is instructive. An excellent case in point is the downfall of “Chainsaw Al” Dunlap at Sunbeam Corp. Jonathan Laing’s 1998 article in Forbes is the subject of Problem 10. Laing demonstrated that Sunbeam’s 1997 reported earnings were almost completely manufactured by means of discretionary accruals. The substantial first quarter, 1998, loss reported by Sunbeam supports Laing’s analysis, and the “iron law” of accrual reversal. I think that Laing’s analysis of the effects of the $17.2 million drop in Sunbeam’s prepaid expenses for 1997 is backwards, and have shown it as a decrease in its effect on net income. Regardless, taking this error into account does not substantially alter Laing’s conclusion that 1997 earnings were manufactured. 4.

Do Managers Accept Securities Market Efficiency?

Evidence of good earnings management is consistent with managers’ beliefs that markets are reasonably efficient. Why use earnings management to reveal inside information if the market cannot interpret it? However, evidence of bad earnings management may or may not be consistent with efficiency. On the one hand, managers may feel that they can fool the market by managing their earnings, which seems to have been the case with Sunbeam management. Emphasizing pro-forma income (Section 7.11.2 is another tactic that seems inconsistent with acceptance of efficiency. It is hard to believe that managers would continue to attempt to manipulate investors’ beliefs if an efficient market immediately detected and penalized such behaviour.

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On the other hand, bad earnings management may hide behind poor disclosure. If the market is not aware that reported earnings are being managed, it can hardly be concluded that the market is inefficient. Rather, the question is whether the market will react once it suspects or becomes aware of the earnings management. The market’s negative reaction to the frequency of non-recurring charges as an indicator of possible earnings management, as documented by Elliott and Hanna (1996) (see Section 11.6.1) suggests considerable efficiency, for example. Also, the market’s post-Enron suspicion of GE’s earnings management, discussed above, is also consistent with efficiency. The text concludes that at least some managers do not accept market efficiency. However, it also concludes that markets are sufficiently close to full efficiency that improved disclosure will reduce bad earnings management. 5.

To Summarize the Strategic Aspects of Accounting Policy Choice

I end my discussion of earnings management with two main points: (i)

I emphasize the concept of strategic accounting policy choice, whereby

managers choose accounting policies to achieve certain objectives. These objectives may include efficient contracting, such as avoiding excess earnings volatility for compensation and debt covenant reasons, which may conflict with accounting policies that are most useful to investors. This greatly expands the role of financial reporting, since we now formally recognize two main roles of financial reporting– reporting to investors and reporting on manager performance. Both roles matter since the quality of manager effort and the well-working of managerial labour markets is as important to society as the quality of investor decisions and the well-working of securities markets. The conflict between these two roles, I hope, validates to the class the time spent on basic game and agency-theoretic concepts of conflict in Chapter 9. (ii)

I emphasize that managers have a legitimate interest in accounting policy

choice, since their operating and financing policies, and even their livelihoods, are at stake. This view is in contrast to many discussions of standard-setting where management seems to be the “bad guys,” opposing every new standard that comes 430 .

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along. The theory provides several legitimate reasons why managers will be concerned about changes to GAAP.

SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

Some reasons why a firm’s management might both believe in securities market efficiency and engage in earnings management are: 1.

Income taxation. The firm may be able to postpone payment of taxes if it can minimize its reported income, for example by managing accruals, or using LIFO (if allowed by the tax authority).

Managerial bonus plan. As Healy documents, managers have incentives to maximize their bonuses, consistent with contract and agency theories. Consequently, if earnings management is hard to detect (e.g., discretionary accruals),they may adopt accounting policies to increase reported net income, or to reduce reported net income if it is below the bogey or above the cap of the bonus plan.

Covenants in lending agreements. Managers may adopt policies to increase reported net income, or other financial statement variables, to avoid covenant violation or even to avoid being too close to violation. Lending agreements may also induce income-smoothing behaviour. A smooth sequence of reported net incomes will reduce the probability of covenant violation.

A smooth earnings sequence may increase the willingness of lenders and suppliers to grant short-term credit. This is particularly so if the firm has implicit contracts with these stakeholders. 431 .

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Political reasons. By reducing its reported net income the firm may forestall government intervention which might ensue if the public felt the firm was earning excessive profits. Problem 8 of Chapter 8 illustrates this point. So does the study of Jones (Section 11.3).

Earnings management can be a credible way to communicate the firm’s inside information about its longer-term expected profitability to the market.

Poor disclosure. The manager may feel he/she can manage earnings opportunistically but hide behind poor disclosure to prevent the efficient market from detecting it.

None of the above reasons are inconsistent with management’s belief in securities market efficiency. Reasons 1 to 4 derive from contractual considerations. Reason 5 derives from political, not securities market, considerations. Reason 6 assumes implicitly that the securities market is efficient, so that the market is aware of the motivation to communicate persistent earning power. Reason 7 is consistent with (semi-strong) securities market efficiency if the market is unaware of the management’s poor disclosure. 2.

Taking a bath involves writing off assets against the current year’s operations, as in lower-of-cost-or-market and impairment test writedowns and/or recording liabilities incurred for reorganizations, layoffs, and other unusual events. As a result, future years’ reported earnings are relieved of amortization, and recorded liabilities for future costs can absorb items that would otherwise be charged against future earnings. Furthermore, if writeoffs are excessive, reversal of the excess will increase future reported earnings. Consequently, future years’ reported earnings will be higher (or losses lower) than they would otherwise be, and the probability of the manager receiving a bonus correspondingly increases.

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Next year’s earnings will be reduced by $1,300 due to the “iron law” of accruals reversal. With respect to credit losses, there is a $500 lower cushion to absorb credit losses in the following year. Consequently, next year’s credit losses expense will be $500 higher, other things equal. With respect to warranty costs, a similar argument applies. The lower the accrued liability for these costs, the lower the cushion to absorb payments for warranty costs in the following year. Consequently, next year’s warranty cost expense will be $800 higher, other things equal.

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You would react negatively. If liabilities increase, the offsetting debit will reduce

reported net income, either currently or in the future, or both. This would reduce your bonus. Your reaction would be less negative if net income before the proposed standards change was above the bogey of your compensation plan. Another reason for a less negative reaction would be that the compensation committee may ignore the effect of the proposed standard change on net income. This possibility would be more likely if the initial charge resulting from the new liability was a one-time, non-recurring (low persistence) item. In this regard, see the evidence of Gaver and Gaver (1998) in Section 10.6, who report that extraordinary gains tend to be included in the determination of cash bonuses but not extraordinary losses.) b.

You would likely react negatively. If you are risk-averse, increased net income

volatility will increase the volatility of your expected stream of future bonuses, thus lowering expected utility. An alternative answer is that the increased volatility would increase the chance that reported net income would fall below the bogey or above the cap of the bonus plan. If this happens, it would require you to either manipulate accruals or forego your bonus. c.

You would react negatively because your expected bonus would be lowered,

with no compensating decrease in bonus volatility. d.

You would react negatively to a reduction in your ability to choose from different

accounting policies, because this would reduce your ability to manage reported earnings through accounting policy choice. In particular, your ability to manager net income for bonus purposes would be reduced. Also, your ability to communicate inside information about long-term earning power to the market (i.e., good earnings management) would be reduced for the same reason. This could adversely affect share price and cost of capital, hence future earnings, reducing your expected bonus payments.

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It is difficult to make general statements about the impact of fair value accounting for financial instruments on opportunistic earnings management, since some aspects of fair value measurement restrict earnings management, and others increase it. The following points can be made: •

When unrealized gains and losses from changes in fair value are included in net income, fair value accounting restricts the ability to manage earnings through gains trading of financial instruments, since the amounts and timing of fair value changes and resulting unrealized gains and losses are then less under management control. Triggering of realized gains and losses through actual sale will be ineffective if the assets and liabilities involved are already recorded in net income at fair value.



Under IFRS 9, financial assets valued at amortized cost are subject to an impairment test. If an impairment writedown is required, determining the new expected value requires considerable manager judgement. This could enable management to manage reported net income.



Under IFRS 9, financial assets valued at amortized cost could be transferred to a fair value basis of accounting, resulting in an unrealized gain or loss in net income. However, this would require a change in the firm’s business model, which IFRS 9 expects will be rare. It seems unlikely that this tactic could be used to manage earnings.



Under current standards in the United States, net income could be managed by simply transferring assets from, say, held-to-maturity to held-for-trading. However, the standard contains strong disincentives for such behaviour.

•

To the extent that unrealized fair value gains and losses are included in other comprehensive income, a form of gains trading is possible since selling financial assets that have increased in value will trigger a transfer from other 435 .

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comprehensive income to net income. This assumes that, for bonus purposes, net income is the performance measure rather than comprehensive income. •

The fair value option can be used to manage earnings. However, under IFRS 9, use for this purpose is restricted, since the option can only be used to reduce a mismatch. The FASB fair value option is more flexible, since its use is not restricted to mismatch situations. It thus offers greater earnings management potential.

•

Fair value accounting standards generally require a great deal of supplementary disclosure. If earnings management based on fair value accounting is carried out, this disclosure makes it more difficult for the manager to hide the earnings management.

•

The previous points assume that well-working market values are available. This assumption will be reasonably met for many financial assets and liabilities. Where such market values are not available, some ability to manage unrealized gains and losses remains, since fair values will then have to be estimated (e.g., Level 3 valuation—see Section 7.2). Also, models to estimate fair values, such as Black-Scholes, require parameter inputs and estimates of the timing of early exercise. These could possibly be manipulated, giving some potential to manage unrealized, and realized, earnings.

•

Under IFRS 9 and ASC 815-20, there may be some earnings management potential in the decision whether or not to designate a financial instrument as a hedge. However, this flexibility is reduced since the designation decision must be made at the inception of the hedge and, once designated, cannot be retroactively un-designated.

A reasonable conclusion is that fair value accounting standards try to prevent opportunistic earnings management. However, it is likely that managers will figure out ways to work around the protections built into these standards. 436 .

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The various accruals for JSA Ltd. are as follows: Add back to net income - Depreciation and amortization.

Deduct from net income

$14

Mainly non-discretionary, since method of amortization and useful lives fixed by policy. However, manager has some discretion to change policy on occasion. - Reduction of liability for future income tax

Non-discretionary, except to extent that manager controls depreciation and amortization policy. - Provision for reorganization, layoffs

Discretionary, to the extent manager controls amount and timing. - Increase in accounts receivable

May be driven by increased level of business activity. However, manager has considerable discretion over allowance for doubtful accounts and some discretion over revenue recognition, credit and collection policy. - Decrease in inventories.

May be driven by lower level of business activity, but seems unlikely since accounts receivable have increased. Manager has considerable discretion over valuation of obsolete, used or damaged items. Also, under lower-of-cost-or-market rule, manager has discretion over amounts of writedowns. 437 .

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- Increase in prepaid expenses.

Considerable discretionary component since manager controls capitalization policy for many of these. - Decrease in accounts payable.

May be driven by lower level of business activity. However, manager controls amounts and timing of purchases and payment policy. Also, considerable discretion to extent accounts payable includes accrued liabilities. - Increase in customer advances.

Largely non-discretionary, although manager may influence number and amounts of advances. - Decrease in current portion of long term debt.

Non-discretionary, since fixed by contract. -

Increase in current portion of future income tax liability.

Non-discretionary, since income tax act specifies. $50 31 Net income-decreasing accruals

$19

Check: Net income

$(12)

Net income-decreasing accruals

Cash flow from operations

438 .

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Note: Students often deduct from net income a $1 accrual for the increase in deferred development costs on the balance sheet. This throws them out of balance. There is not enough information on the income statement to know if deferred development costs are being amortized. It appears not. The most likely explanation for the increase in this item is that it results from a non-operating transaction, such as cash paid out for some capitalized development cost. b.

Use the Jones model, which is a regression equation to estimate non-

discretionary accruals after allowing for the (non-discretionary) levels of business activity and capital investment. Once the regression model is estimated, use it to predict current period total accruals Discretionary accruals are then taken as the difference between this estimate and total accruals. Ii) c.

Use total accruals, since total accruals contain discretionary accruals.

The manager may take a bath, by recording impairment writedowns for

investments in capital assets and recording liabilities for future costs such as reorganization and layoffs. This will reduce reported net income this year, but the probability of high net income in future years is increased, since future amortization charges will be lower and future payments for reorganizations and layoffs can be charged against the liabilities rather than against future net income. Furthermore, if the writeoffs and liabilities turn out to be higher than actually needed, the excess amounts can be reversed into future years’ operations. However, a tactic of deliberately overstating writedowns and provisions may not be desirable since accounting standards now prohibit such overstatements. This could result in restatements of previous financial statements and, quite possibly, lawsuits and charges from securities regulators. Alternatively, the manager may income maximize, so as to increase net income above the bogey. However, this tactic is unlikely to be used unless pre-bonus earnings are only slightly below the bogey. Obviously, the most suitable accruals above are those with the greatest discretion, and relative invisibility. To lower reported net income, these include maximization of accrued liabilities, more conservative revenue recognition, minimization of prepaid 439 .

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expenses, the allowance for doubtful accounts, and inventories. The effect on net income of these tactics may not be enough to achieve the big bath objective, however. Changes in amortization policy and useful life estimates of capital assets are possibilities. However, they are quite visible and could not be used very often. The most likely accrual is providing for reorganizations and layoffs. However, in view of current accounting standards concerning such special items, the manager would have to be careful not to overstate them.

Reasons to resort to extreme earnings management tactics: •

To meet analysts’ forecasts. As stated in the question, this was the apparent reason in BMS’ case.

•

Contractual reasons. To increase bonuses and/or to avoid debt covenant violations.

•

Implicit contracts. To increase earnings so as to receive better terms from suppliers. In BMS’ case, this seems unlikely since wholesalers were pressed to accept excess inventory.

•

New or additional stock offerings. The firm may have wanted to increase and/or smooth earnings so as to increase proceeds from a planned stock offering.

From the standpoint of a single year, stuffing the channels seems effective.

This is because it is hard to detect. Such behaviour may possibly be detected through full disclosure, such as sales by product, segment, or region. Then, careful analysis may reveal unusual sales patterns. However, the company has little motivation to provide full disclosure unless required by GAAP and/or insisted upon by the auditor. Wholesalers may object if too much inventory is forced upon them. Since wholesalers are not formally BMS employees, it may be more difficult to keep them from

440 .

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complaining to regulators or the media. However, in BMS’ case, paying their carrying charges may have been a device to avoid such complaints. Over a series of years, stuffing the channels is likely to be less effective, for the following reasons: •

Accruals reverse. Product stuffed into the channels this year will reduce sales next year. Ever more stuffing is needed if the strategy is to be maintained.

•

Physical limitations. There may be limits on wholesalers’ storage space.

•

Cost. It seems that paying the wholesalers’ carrying costs for their excess inventory became quite costly for BMS.

We conclude that while stuffing the channels may be reasonably effective in the short run, it loses effectiveness to the extent it is used over multiple periods. c.

BMS appears to have been using cookie jar accounting to smooth reported

earnings. Cookie jar accounting seems reasonably effective as an earnings management device since it can be hard to detect. Overproviding for losses puts future earnings (i.e., cookies) in the bank (jar). Also, GAAP does not require separate disclosure of the effect on operating earnings when these accruals reverse. However, disclosure of unusual, low-persistence special items, particularly if such special items appear frequently over time, may tip off an efficient market as to the possibility of cookie jar accounting. This effect was documented by Elliott and Hanna (1996)—see Section 11.6.1. While even an efficient market will not really know the actual extent of such accounting without full disclosure, suspicions may lead to SEC investigation. This seems to have happened to BMS. Furthermore, excess provisions and reserves are now contrary to GAAP, and if discovered will lead to restatements of financial statements, charges by securities regulators, and lawsuits. Effectiveness of cookie jar accounting can be increased if it is used responsibly to reveal management’s estimate of persistent earning power (i.e., good earnings management). It seems unlikely that BMS was using it in this manner, however. 441 .

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We conclude that while cookie jar accounting may have been reasonably effective until about 2002, new accounting standards make cookie jar accounting contrary to GAAP. This tactic is now very dangerous as an earnings management device.

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Restructuring charges are an effective earnings management device. They are

a non-recurring special item, hence of low persistence. As a result, they may be ignored by analysts and investors in evaluating operating earnings, and by compensation committees for bonus purposes. Their effectiveness is enhanced since restructuring charges can be used to reduce current reported earnings if needed to smooth earnings down to an amount that management feels will persist. GE appears to have used this strategy, as evidenced by Table 11.3 (until 2008). Also, from an opportunistic perspective, excessive restructuring charges can be used to put future earnings in the bank. Banking is accomplished since future costs that might otherwise be charged to operations, can be charged to the restructuring allowance. Note: The effectiveness of restructuring charges as an opportunistic earnings management device is reduced by more recent accounting standards that prohibit recording a restructuring provision until a liability is incurred. Such liabilities are to be recorded at fair value. In effect, excessive restructuring charges are now contrary to GAAP. b.

It seems unlikely that GE’s share price always fully reflects all publicly available

information. Costs of fully analyzing all information contribute to lack of full market efficiency. In GE’s case, costs of analysis are particularly high, since the firm’s complexity makes it difficult even for analysts to fully interpret GE. Also, investors who wish to eliminate idiosyncratic risk would find it difficult to find similar firms to invest in. Thus, any anomalies and resultant mispricing of GE shares are likely to persist. However, any mispricing will be reduced, if not eliminated, if GE’s management uses earnings management responsibly to reveal its expected persistent earning power, since share prices are based to a considerable extent on expected future earnings. If management’s inside information about expected earning power is accurate, and its reported earnings are a credible measure of this expectation, GE’s share price should trade at a price similar to its efficient market price. c.

It seems that GE used earnings management responsibly to convey inside

information about expected earning power. The company did this by using a variety of 443 .

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earnings management devices to report a smooth, increasing net income series that, until the market meltdowns of 2008, persisted. This strategy stands in for the difficulty analysts and investors face in fully evaluating all available information themselves. As a result, GE’s share price should have reasonably reflected its expected future performance during 1993-2007. We conclude that, in this period, GE’s earnings management was good. 9.

Rational investors would have had high prior probabilities of continuing

improvements in GE’s future firm performance, despite the economy-wide decreases in share prices during 2007-2008. This is because of GE’s past history of earnings increases, because analysts had predicted higher-than-reported earnings, and because the company had given no prior warning of the earnings shortfall. GE’s share price fell because, given no prior warning, shareholders quickly revised downwards their estimates of future firm performance once they received the current earnings message. On the basis of this downward revision, many investors decided to sell their shares, driving share price down. b.

A firm’s management has the best inside information about future expected

earning power. This is particularly so for large complex firms like GE, where investors, and even analysts, find it particularly difficult to predict future earnings based on publicly available information. If management simply announced its expected future earnings, this would have little credibility, since the market knows the manager has an incentive to inflate the estimate (blocked communication). However, management can reveal this blocked inside information by managing reported earnings to a number that it feels will persist. This way of unblocking the information is credible because management has formal responsibility for the financial statements and the manager would be foolish to report more earnings than can be maintained. That is, if current earnings are managed to an amount greater than persistent earnings, accrual reversal will cause future earnings to fall. This will result in severe share price decline and damage to manager reputation. 444 .

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GE management must have known by 2008 that constantly increasing

earnings could not be maintained. Then, managing current earnings upwards beyond what is expected to persist (i.e., bad earnings management) would result in lower future reported earnings. The result would be an even greater fall in share price in future than the fall that occurred in 2008, since it would be apparent that GE had overstated its past earnings. This would cause investors to increase their estimation risk. Yes, GE’s reporting of lower earnings this quarter is consistent with good earnings management. Given its past history of good earnings management, it is likely that the lower reported earnings reported this quarter represents a number that GE feels will persist. This is reinforced by its cost-cutting program and increased surveillance of subsidiaries. 10.

Total accruals can be determined as the difference between net income and

operating cash flow: $109.4 - (-$8.2) = $117.6 We may conclude that $90.5 million of the total accruals of $117.6 million were discretionary, income-increasing. It thus appears on the basis of Laing’s analysis that Sunbeam’s 1997 reported earnings were largely manufactured. b.

Hanna argued that restructuring charges were frequently excessive. If so, this

would put earnings in the bank, which Sunbeam can draw down in future years through reduced amortization and charging of future operating costs to the restructuring provision. c.

While a decline in actual sales may be at least partly responsible for the first

quarter loss, the reported sales would have been pulled down by the reversal of the $50 million “early buy” and “bill and hold” sales accruals recorded in 1997.

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With respect to expenses, some of the expense reductions, such as amortization, noted for 1997 would continue in 1998. However, many others would reverse, such as warranty expense, allowance for doubtful accounts, and manufacturing for stock (which would lower 1998 production, hence the amounts of absorbed overhead). In sum, the early recording of sales in 1997, together with the reversal of discretionary, income-increasing 1997 accruals, seems to have “come home to roost” in 1998, consistent with the iron law of accruals reversal. Note: Subsequent articles relating to Sunbeam’s accounting problems include: •

“Troubled Sunbeam ousts CEO Al Dunlap,” The Globe and Mail, June 15, 1998, p. B6 (reprinted from The Wall Street Journal).

•

“Teary-eyed Chainsaw Al defends record at Sunbeam,” The Globe and Mail, July 10, 1998, p. B8 (reprinted from The Wall Street Journal).

•

“Sunbeam audit finds mirage, no turnaround,” The Globe and Mail, October 20, 1998, p. B15 (reprinted from The Wall Street Journal).

•

“Despite Recovery Efforts, Sunbeam Files for Chapter 11,” The Wall Street Journal, February 7, 2001.

•

“S.E.C. Accuses Former Sunbeam Official of Fraud,” The Wall Street Journal, May 16, 2001. Arthur Andersen partner Philip E. Harlow was also charged.

•

“Sunbeam’s ex-CEO settles SEC probe,” The Globe and Mail, September 5, 2002, p. B6. The article reports that Mr. Dunlap will pay $500,000 (U.S.) to settle charges he used inappropriate accounting techniques that hid Sunbeam’s financial problems. Former CFO Russell Kersh will pay $200,000. Both men were barred from ever serving as officers or directors of any public company. Mr. Dunlap has also paid $15 million and Mr. Kersh $250,000 to settle a class action lawsuit over misrepresentation of Sunbeam’s results of operations. 446 .

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“Morgan Stanley duped financier Perelman in ‘fraudulent deal’,” Financial Times, April 7, 2005, page 16. The Laing article mentions Sunbeam’s acquisition of Coleman Co., a maker of camping equipment. The Financial Times article reports that Ronald Perelman, a wealthy financier and chairman of cosmetics firm Revlon, is suing Morgan Stanley, a large investment bank. Perelman had owned 82% of Coleman, and accepted Sunbeam shares as payment. The lawsuit claims that Morgan Stanley helped Sunbeam “dupe” Perelman about the value of Sunbeam shares, which collapsed in value when the earnings management described in the Laing article was revealed.

•

Ball (2009) reports that Arthur Andersen, Sunbeam’s auditor, paid a total of $110 millions in lawsuit settlements arising from Sunbeam’s earnings management.

11.

Managers may want to smooth earnings for the following reasons: •

They may feel that the market rewards share prices of firms that report steadily increasing earnings.

•

They may want to keep earnings for bonus purposes between the bogey and cap of their bonus plan.

•

They may want to reduce the probability of violation of debt covenants.

•

They may want to convey inside information about persistent earning power by smoothing reported earnings to an amount they feel can be sustained.

•

They may smooth earnings because of implicit contracts (Section 8.10.1). The firm may be able to secure better terms from suppliers and other stakeholders with which it has a continuing relationship if it reports smooth earnings. 447 .

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Costs of smoothing earnings by means of opportunistic discretionary accruals

derive primarily from negative investor reaction should the firm’s usage of such discretionary accruals to manipulate earnings be discovered by the market. This is likely since accruals reverse. Investors may then lose confidence in the integrity and transparency of the firm’s reporting (i.e., their perception of estimation risk increases), leading to a fall in its share price. Costs of smoothing earnings by means of derivatives include the commissions and other costs paid in order to acquire and sell the derivative instruments. Also, if the firm excessively smooths its earnings in this manner, this reduces the manager’s incentive to exert effort, since agency theory tells us that if he/she is to work hard, the manager must bear risk. Another potential cost is that hedging by derivatives reduces upside risk. The firm will not benefit if underlying prices move opposite to the direction hedged. Smoothing by accruals does not have this effect. Managers will trade-off these 2 earnings management devices in order to minimize costs. Smoothing by means of derivatives involves the use of real variables to manage earnings, with costs as given in the previous paragraphs. Smoothing by means of accruals also creates costs, deriving from increased investor estimation risk should opportunistic earnings management be revealed. Also, firms may differ in the amounts of discretionary accruals available. For example, firms that operate in a risky environment, or that are continually buying and selling other companies and engaging in costly restructurings, have more accruals-based earnings management potential than a stable firm in a stable industry where, for example, there may be relatively few large one-time items with earnings management potential. Stable firms would find it less costly to smooth by means of derivatives. Other firms may already be heavy derivatives users and may be concerned that further usage could turn into speculation, which could increase, rather than reduce, volatility of earnings. Alternatively, firms may be in a business for which a derivatives market does not exist or is very costly. For example, a firm with operations very 448 .

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subject to the weather may find weather derivatives to be too costly. Such firms would find it less costly to smooth earnings by means of discretionary accruals. c.

Barton’s results are more consistent with efficient contracting. If managers were

not concerned about the costs to the firm of smoothing activity, they would not tradeoff the use of discretionary accruals and derivatives so as to find the lowest-cost way to smooth. Note: An alternative argument is that Barton’s results are more consistent with opportunistic contract theory. Smoothing earnings, be it by discretionary accruals or derivatives, may add to manager reputation, reduce the likelihood of debt covenant violation (which would adversely affect manager reputation and reduce his/her freedom to operate the firm), and increase expected utility of compensation (by reducing the volatility of earnings-based bonuses). However, managing earnings by means of discretionary accruals incurs costs to the manager when the opportunism is discovered. Using derivatives for part of the desired smoothing reduces the expected costs of accrual-based earnings management and transfers some of the smoothing costs to the company. 12.

Nortel recorded additional provisions in its fourth quarter, 2002. The effect was

to further lower its GAAP loss and to change its pro-forma earnings from a profit to a loss. This suggests a policy of income minimization for the quarter. Since positive pro-forma earnings would trigger management bonuses for the quarter, despite a GAAP loss, the company claimed that this would attract criticism from investors. The additional provisions, while further lowering GAAP earnings, also changed the pro-forma profit to a loss, so that no bonuses were paid. However, an additional reason was likely. The reversal of the 2002 provisions in 2003 would increase 2003 pro-forma earnings, increasing the probability that bonuses would be paid in first quarter, 2003. The company may have also reasoned that the reversals could be timed to increase the probability of positive pro-forma earnings in subsequent 2003 quarters, in which case, additional bonuses would be paid. Thus

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Nortel appeared to have followed an earnings management policy of income maximization in the first two quarters of 2003. b.

Contract theory supports the practice of conservatism. Reasons are: •

Conservative accounting increases the security of debtholders.

•

Conservative accounting, by recording unrealized losses but not unrealized gains, makes it more difficult for managers to enjoy higher compensation and reputations by including unrealized gains in earnings.

•

Conservative accounting, by recording unrealized losses, brings these to the attention of investors and Boards of Directors, increasing the likelihood that timely actions will be taken to correct the policies that have led to the losses.

Conservatism is also supported by concerns about legal liability. Since investor lawsuits are more likely following unexpected losses than unexpected gains, conservative accounting (impairment testing) reduces the amounts of realized losses, reducing expected lawsuits. c.

A likely impact on manager effort would be to increase it, since bonuses would

be paid for a return to profitability. However, the increased effort motivation would be reduced by defining profitability as pro-forma profits, rather than GAAP net income. Management has greater flexibility to omit losses from pro-forma earnings, so that a return to pro-forma profitability could likely be achieved with less effort than under GAAP net income. d.

The reasons for management dismissals in 2004 were not due to the

conservative nature of the 2000-2003 special items. Indeed, the court agreed that conservatism was a well established practice. Rather, they were due to management’s timing of the reversals of these excess provisions. By 2004, it was clear (but perhaps not to the court) that management had opportunistically managed these reversals so as to maximize bonuses, despite the reporting of revised GAAP losses in the first two quarters of 2003. 450 .

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if the new special items provisions had been in effect in 2000-2003, these

events would likely have happened anyway. Under both U.S. and IASB GAAP, such provisions have to be fair valued. However, there would be few. If any, market values available to guide the provision amounts. This means Level 3 valuations are necessary, which are subject to considerable management judgment. Given the pessimistic economic conditions at the time, management’s conservative estimates would likely have met the new standards. This argument is strengthened by the court’s acceptance of conservative accounting. However, the new provisions also prevent recording a provision until a liability is incurred (FASB), and require that payments be probable and capable of reliable estimation, and any reversals fully disclosed (IASB). These requirements might have delayed and/or reduced the amounts of the original provisions. A reasonable conclusion is that the conservative provisions would likely still have been made under the new rules, but that their amounts would have been somewhat lower. 13.

The current financial report shows GN. The persistence of the special item is

low by definition. Thus, it is unlikely to have much negative effect on future earnings. Indeed, if the special item is due to a reorganization, this may well increase future operating efficiency and earnings. Also, future earnings will be increased to the extent that the current special item reduces future amortization charges and/or provides a cushion against which future charges can be debited. Note: Answers that argue BN on the grounds that the analysts’ consensus forecast was only met, not exceeded, are not acceptable. Under the circumstances (increased earnings before a large low-persistence loss which may well indicate higher future net incomes) it seems hard to interpret current earnings as BN. b.

By Bayes’ theorem, the posterior probability of the high state, based on GN in

earnings, is: 451 .

Scott, Financial Accounting Theory, 7th Edition P( High / GN ) =

Instructor’s Solutions Manual Chapter 11

P( High) P (GN / High) P(GN / High) P( High) + P (GN / Low) P ( Low) 0.7 × 0.9 0.63 63 = = 0.9 × 0.7 + 0.2 × 0.3 0.63 + 0.06 69

= 0.91 P ( Low / GN ) = (1 − 0.91) = 0.09 Then, denoting holding the shares by a1: EU (a1 ) = 0.91× 100 + 0.09 × 36 = 0.91×10 + 0.09 × 6 = 9.10 + .54 = 9.64 EU (a2 ) = 81 = 9

The decision is to hold. Note: If the answer to a is BN, an answer that correctly evaluates the resulting decision is acceptable: P(High/BN) = 0.23 EU(a1) = 6.9 EU(a2) = 9 c.

Yes, your evaluation of the earnings report should now be BN. The shortfall in

earnings per share may suggest a break in HILO’s sequence of steadily increasing 452 .

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earnings. This concern is increased by the special item, which may be management’s way to smooth reported net income down to a level that it expects will be earned in future. Also, managers know that the market price of their shares will be severely affected if earnings expectations are not met. If HILO cannot find enough earnings management to raise reported earnings (before special item) by 2 cents per share, the firm’s earnings outlook must be questionable.

14.

The revenue deferral will decrease relevance, since there is now a greater

recognition lag for contract revenue. This reduces the ability of investors to predict future firm performance. However, by waiting until delivery (the usual basis of revenue recognition) reliability will increase, since there is now less chance of error or bias in the amounts of revenue recognized. b.

Nortel appears to be following a pattern of big bath for 2005. The shareholder

litigation expense item creates a large loss for the year. Nortel may feel that this would be a good time to defer revenue, since there is a large loss anyway, and, since accruals reverse, deferral now will increase revenue to be recognized in future periods. c.

Abnormal return is the difference between expected and actual share return for

the day. From the market model, the expected return for Nortel for t = March 10/06 was: Rjt = αj + βjRMt, where αj = Rf(1 – βj) = .0001(1 – 1.96) + 1.96 × .0058 = -.0001 + .0114 = .0113

453 .

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The actual return on Nortel shares for this day was - .0305. Abnormal return was thus – .0305 - .0113 = - .0418, or – 4.18%. The negative abnormal share return arose, at least in part, because of the revenue deferrals, since the market would have been aware of the shareholder litigation and would have incorporated the expected settlement amount into Nortel’s share price prior to March 10. An efficient market would realize that while the revenue deferrals decreased 2004 and 2005 earnings, they would increase future earnings. Thus, the market reaction to the deferrals themselves would be small. However, the news of the deferrals would cause investors to lose confidence in Nortel’s accounting, increasing estimation risk. Also, if the $2.474 billion special item exceeded the market’s expectation, this would also contribute to the negative return. An argument based on securities market inefficiency can also be supported. The market may not have incorporated an expected settlement amount into Nortel’s share price prior to the news of the $2.474 billion settlement on March 10. Also, the market may have reacted negatively to the lower earnings because of the revenue deferrals, without realizing that the effect of the deferral is to increase future earnings. 15.

Revenue recognition is an effective earnings management device because

recognition criteria under GAAP are vague and general. A company can speed up revenue recognition but disguise the change through vague wording of its revenue recognition accounting policy disclosure. Also, as in the case of Coca-Cola, revenue recognition can be speeded up by stuffing the channels to unconsolidated subsidiaries or customers, without any formal change in revenue recognition timing. Stuffing the channels can be difficult for investors, or even auditors, to detect. A superior answer will point out that generating increased revenue by changing the timing of its recognition is an accruals-based earnings management policy, whereas, stuffing the channels generates increased revenue by means of real variables. A disadvantage of changing the timing of revenue recognition as an earnings management device is that accruals reverse. Consequently, changing the timing of 454 .

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revenue recognition may increase current recognized revenue, but there will be a corresponding decrease in revenue of future periods. Thus, after a few periods of stable operations, the amount of revenue recognized per period will be the same as the amount recognized before the timing change. A disadvantage of stuffing the channels is that it is difficult to maintain increased reported revenue over time. Recording stuffing revenue this period reduces revenue of next period. Possible reasons why a firm may manage its reported earnings upwards: •

Contractual. To smooth or otherwise manage executive compensation where this is based on reported earnings, and to reduce the probability of violation of debt covenants.

•

To meet analysts’ earnings projections, thereby avoiding a fall in share price. This seems to be the most likely reason in Coca-Cola’s case.

•

To maintain or increase management’s reputation.

•

Income taxes. To reduce or otherwise manage income taxes payable.

•

Changes in CEO. CEOs may manage earnings to reduce the probability of being fired, to reduce the probability of a successful takeover bid, or because they are approaching retirement.

•

IPOs. Firms may manage earnings upwards prior to a stock offering so as to increase the issue price.

•

Implicit contracts. To maintain good relations and credit terms from suppliers. This seems unlikely in Coca-Cola’s case, however.

•

Communicate inside information to investors, providing the upward management is not to an amount higher than can be sustained. Again, this seems unlikely in Coca-Cola’s case. 455 .

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Since gallons shipped in one quarter correspondingly reduce amounts shipped

in future quarters, an increase in EPS this quarter will create a corresponding decrease in EPS next quarter. Consequently, even more gallonage must be pushed in each successive quarter to maintain an EPS increase. c.

The underlying reason, of course, was that inventory levels were no longer

sustainable. The reason for calling the curtailment of the pushing program an inventory reduction to optimum levels was so that the inventory reduction could be explained as a one-time item, creating the appearance of low persistence. Coca-Cola probably felt that this would reduce negative investor reaction to the inventory reduction and to lower sales and earnings in 2000. d.

Large public companies may discontinue earnings forecasts to avoid the

negative consequences resulting from the pressure of meeting them. Forecasts provide an incentive for the manager to exert effort to attain forecasts. However, if it appears the forecast will not be met in the normal course of business, the manager may attempt to meet them through dysfunctional behaviour such as bad earnings management, excessive cost-cutting, and/or deferral of maintenance. In effect, meeting forecasts encourages short-run behaviour at the expense of longer-term firm interests. The SEC charges resulting from Coca-Cola’s 1997-1999 “gallon pushing” may have contributed to this decision. 16.

Stock repurchases lower the denominator of the EPS ratio. For given net

income, this increases EPS. However, net income in the numerator will be decreased because of higher interest expense if the repurchase is financed by borrowing, or by lower earnings due to less cash employed in the business if financed internally. Earnings per share will decrease if the reduction in the number of shares outstanding is outweighed by a resulting decline in net income. b.

Arguments in favour of share buybacks as an earnings management vehicle:

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• Accrual management may be interpreted as bad by the market, whereas it is unlikely that share repurchases will be interpreted this way. • Even if not interpreted as bad, accruals reverse. This will reduce earnings in future periods. To avoid lower earnings, more and more income-increasing accruals must be found. Eventually, it will be impossible to find enough accruals, and the earnings management will be revealed. Stock repurchases do not reverse, and, if they increase EPS, this increase will persist. • Amounts and timing of stock repurchases can be managed in each period so as to produce a steady increase in EPS. It becomes increasingly difficult to produce a steady increase in earnings by use of accruals. Arguments in favour of accruals: • Stock repurchases are an effective earnings management device only to the extent that analysts and investors look to EPS as a measure of firm and manager performance. To the extent that they look to net income, stock repurchases lose effectiveness for earnings management. • Share repurchases reduce net income and may reduce EPS. Accruals are more flexible since they can be used to either increase or decrease net income and EPS. • Stock repurchases may help managers meet analyst earnings forecasts and avoid debt covenant violations only if they increase EPS, and also only to the extent that analyst forecasts and debt covenants are in terms of EPS. If forecasts and debt covenants are in terms of net income, stock repurchases may make these targets more difficult to meet. Whether or not you agree with the manager depends on your assessment of which set of arguments is strongest. c.

Your answer depends on whether the performance measures in the

compensation contract are in terms of EPS or earnings. If in terms of EPS, and if 457 .

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share repurchases increase EPS, share repurchases are an effective device to increase compensation. If in terms of earnings, share repurchases lose effectiveness, since they may decrease net income, in which case the compensation contract would not drive stock repurchases. However, even if performance measures are in terms of net income, a high and increasing series of EPS may increase manager reputation, reservation utility, and job security. The prospect of higher reservation utility, which could result in better future compensation contract terms, could then drive stock repurchases. To the extent that stock repurchases increase share price, due to less dilution and positive market response to higher earnings per share, stock buybacks may increase the value of stock-based compensation even if bonus based on net income is lower. Thus stock-based compensation in the compensation contract could drive stock repurchases. 17.

Under ideal conditions, the two measures are equal. This is because

replacement cost is the current market price to buy an asset and fair value is the current market price to sell an asset (i.e., exit price). In both cases, market price is the (expected) present value of future cash receipts from the asset. Should these two prices differ, the process of arbitrage would immediately take place to restore equality. b.

Earnings as per IASB standards are based to a considerable extent on fair

value accounting, that is, exit price, supplemented with extensive disclosures. Valuation of assets and liabilities at exit price in effect charges the manager with the selling price of net assets (i.e., opportunity cost).Then, earnings based on fair values is interpreted as the ability of the manager to earn a return on the selling price of net assets used in the business. If this return equals or exceeds the firm’s cost of capital, the manager’s performance is satisfactory or better. If the manager is unable to earn cost of capital on exit price of net assets, performance is unsatisfactory. The manager is motivated to work to avoid this unsatisfactory outcome since shareholders would be better off to sell the assets or hire a manager who can earn cost of capital.

458 .

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Replacement cost-based profit is based on the going concern concept of historical cost accounting. If the firm is to remain in business, the manager must be able to replace the net assets consumed in the process of earning revenue. If profits are sufficient to at least replace net assets consumed, manager performance is satisfactory or better. Otherwise, performance is unsatisfactory. The manager is motivated to work to avoid this unsatisfactory outcome since, if the firm is to remain in business, it must be able to replace what it has sold or, if not, replace the manager with someone who can earn at least replacement cost of net assets consumed. A problem with replacement cost, however, is that technology and business practice are constantly changing, and thus net assets are unlikely to be replaced in kind. Consequently, profit sufficient to replace net assets consumed does not necessarily mean that manager performance is satisfactory, since ability to replace assets consumed does not guarantee survival of the firm. earnings based on fair value accounting is less subject to this problem, since the selling price of net assets reflects changes in technology, and in consumer preferences—existing assets, even if in perfectly good condition, will not be worth replacing if better technology is available and/or if consumer preferences have changed. Including fair value gains and losses in earnings alerts the manager that changes in technology and preferences must be adapted to. Since markets are incomplete, a problem with fair value accounting is that reliable measures of fair value are not available for all assets and liabilities. Consequently, management may behave opportunistically to manage fair value gains and losses, hence reported earnings, for its own purposes. But, reliable determination of replacement costs is also subject to the problem of market incompleteness. Thus, differences in reliability are not a basis for choosing between the two income measures. A reasonable conclusion is that, in a dynamic firm environment, earnings based on fair value is superior to profit based on replacement cost accounting in its ability to motivate and monitor manager performance.

459 .

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According to BP, underlying replacement cost profit is “closely tracked by

management to evaluate operating performance and make financial, strategic, and operating decisions.” If this is the way management runs the business, then replacement cost profit has potential to give useful information to investors about future cash flows. This argument reasonably applies to adding back holding gains and losses on inventories. To the extent that BP will be replacing its inventories, replacement costs give a better indication of future cash flows than historical costs. However, BP has recorded numerous non-operating items, such as writeoffs of projects, impairment tests, and provisions for costs arising from the Gulf of Mexico oil spill. Many of these items imply an effect on future cash flows (i.e., they are persistent). For example, project abandonments and sales of refineries will certainly affect future cash flows. Replacement cost profit omits these items. A reasonable conclusion is that to the extent non-operating items are persistent, replacement cost profit is inferior to GAAP earnings in informing investors about future firm performance. d.

To the extent that management uses replacement cost profit to manage

operations, and to the extent that it actually replaces inventory sold in the period, replacement cost profit should be more useful than IASB GAAP in guiding management’s operating decisions. However, if replacement cost profit is also used to make financing and strategic decisions, use of replacement cost profit is questionable. Certainly, the numerous project abandonments, impairment losses, and provisions for oil spill costs recorded in the quarter suggest that unfortunate decisions have been made in the past. Adding such costs back to net income may cause management to feel that non-operating gains and losses are not important, leading to less care in making longer-term decisions. Also, adding financing and tax costs back to net income may cause management to feel that decisions relating to capital structure and tax minimization are not important. 460 .

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Even with respect to operating decisions, adding inventory holding gains and losses back to earnings can be questioned. This may cause management to feel that maximizing sales revenue is most important. However, management is also responsible for wise buying. Ignoring inventory holding gains and losses may lead to lack of manager attention to decisions about timing, amounts, and hedging of inventory purchases. We conclude that replacement cost profit is not a better basis for performance evaluation and decision making than GAAP earnings. 18. Under historical cost accounting, capitalization of marketing costs for a growing company has some conceptual justification. If the costs benefit the future, then they should be matched with the future revenues generated by the marketing costs. To the extent that once customers buy a coupon from Groupon they continue to be customers, capitalization and amortizing the cost of obtaining those customers does result in matching, much like capitalizing and amortizing the cost of plant and equipment is justified by the matching criterion. From a current value accounting perspective, emphasis is on the current value of the future benefit generated by the marketing costs, that is, on the balance sheet valuation of these costs. In principle, this value is the expected present value of the profits generated from the future business that results from current marketing efforts, or from the market value of this future business should Groupon sell its customer base. Then, amortization would not be needed, since earnings would include any change in current value during the period. However, a problem with both an historical cost and current value justification for capitalization is reliability. Capitalization and amortization under historical cost requires the determination of whether current marketing costs will benefit the future and, if so, for how long. Estimating expected cash flows from the future benefits, or the market value of these benefits, under current value is similarly complex. In both cases, significant management judgment is required, possibly leading to error or bias. This concern is magnified by the fact that Groupon is a young company and seems unique 461 .

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in its business model. This makes it even more difficult to, for example, estimate the extent to which customers will engage in repeat business. The problems here are similar to the problems of accounting for R&D. Given the difficulties and reliability concerns of estimating future benefits or market value of R&D, accountants write research costs off currently. Thus a reasonable conclusion is to disagree with Groupon’s marketing cost capitalization policy. b.

A less aggressive way to account for Groupon’s revenue would be to recognize

revenue net, that is, only the amount that Groupon expects to retain for itself. The difference between the total amount paid by the customer and Groupon’s retention would be recorded as a liability. Note: Under the Groupon gross policy, it seems that amounts owing to merchants are recorded as an expense only as paid. c.

it seems that Groupon management does not fully accept securities market

efficiency. If it did accept efficiency, it would make little sense to record revenue gross, since an efficient market would see through this policy and make its own adjustment for amounts owed to merchants. Also, Groupon’s ASCOI policy would make little sense since the market would recognize that the future value of marketing costs is extremely difficult to determine and subject to manager bias. The market would probably disregard most of the book value assigned to it by Groupon. d.

The enthusiastic securities market acceptance of the Groupon IPO and, in

particular, the rapid runup in share price in early trading, seems inconsistent with market efficiency, particularly since Groupon’s aggressive policy of revenue reporting and its ASCOI emphasis were publicly known at that time. However, market efficiency is defined relative to publicly available information. The material weakness in internal controls leading to undervaluation of expected customer refunds seems not to have been publicly known until April, 2012. The rapid fall in share price to $13 in April suggests considerable efficiency. The further fall to about $5 also suggests efficiency since it appears to have been due to increasing concerns about a reduction in the customer base. Even the rapid rise in share price in early 462 .

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trading following the IPO could be consistent with efficiency if available information about the rise in Groupon’s customer base created rational beliefs that, despite the aggressive accounting policies, future cash flows and earnings would be sufficient to justify a $33 share value. Nevertheless, a reasonable conclusion is that the evidence with respect to market efficiency is mixed.

463 .

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Additional Problems 11A-1. This problem is based on the paper by Elliott, Hanna, and Shaw (EHS), “The Evaluation by the Financial Markets of Changes in Bank Loan Loss Reserve Levels,” The Accounting Review (October, 1991), pp. 847-861. While the main research interest of this article is information transfer (the impact of a firm’s financial statements on the share prices of other firms—on this topic, see Lambert, Leuz, and Verrecchia (2007) in Section 12.9.1), the evidence in the paper also provides an interesting and persuasive illustration of how earnings management (in this case, the establishment of loan loss reserves) can reveal inside information. During 1987, many United States banks faced severe problems with respect to loans to “lesser developed countries” (LDCs). For example, on February 20, 1987, Brazil declared a moratorium on interest payments on $67 billion of its debt. This led to problems of how to account for the LDC loans by the banks that were affected. On May 19, 1987 (4.45 pm , i.e., after markets closed at 4PM), Citicorp (a moneycenter bank and, at the time, the largest U.S. bank) announced a $3 billion increase in its loan loss reserve for LDC loans. This amount equalled 25% of the book value of its LDC loans. In the 2 days following the announcement, Citicorp’s share price rose by 10.1%, after falling by 3.1% on May 19. The market had possibly anticipated the4.45 pm announcement. EHS also examined the share price behaviour of 45 other U.S. banks with foreign loans in excess of $100,000 and which announced increases in their loan loss provisions during 1987. Of these banks, 11 (excluding Citicorp) were money-center banks (with major LDC exposure) and 34 other, regional banks (with lower LDC exposure). For a 3-day window surrounding the May 19, 1987 Citicorp announcement, EHS report the following abnormal returns: 11 money-center banks:

1.14%

34 other banks

-.054% 464 .

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On December 14, 1987 (4.15 pm), the Bank of Boston (not a money-center bank) announced a $200 million increase in its LDC loan loss reserve, classified $470 million of LDC loans as non-accrual of interest status, and wrote off $200 million of LDC loans. In the 3-day window centred on 15 December, 1987, its share price rose by 9.9%. Banks were required to maintain a capital adequacy ratio (see note) of at least 5% for regulatory purposes. The Bank of Boston’s capital adequacy ratio remained strong (8%) after the writeoff. Note: The capital adequacy ratio is calculated as the ratio of shareholders’ equity plus loan loss reserves to total assets. Thus, a provision for loan losses does not affect the ratio (i.e., debit shareholders’ equity, credit loan loss provision), while a writeoff of loans does. For a 3-day window centred around 15 December, 1987, EHS report the following abnormal returns: 12 money-center banks

-7.26%

33 other banks

- 1.14%

Required a.

Why did Citicorp’s share price fall by 3.1% on May 19, 1987 and rebound by

10% over the next two days? b.

Why did the abnormal 3-day return for 11 money-center banks exceed the

return for the 34 other banks for the same period? c.

Why did the Bank of Boston’s share price rise by 9.9% over a 3-day window

surrounding December 15, 1987? d.

Why was the average abnormal return of 12 money-center banks significantly

lower (-7.26%) than the abnormal return of 33 other banks (-1.14%) over the 3-day window surrounding December 15, 1987?

465 .

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11A-2. Shown below are the income statement and comparative balance sheets of ACR Ltd., from its 2008 annual report. The 2008 cash flow statement of ACR Ltd. (not shown) reports operating cash flow as $2,386. ACR Ltd. Income Statement Year Ended December 31, 2008 Contract income

$11,684

Cost of contracts

9,073

Gross profit

2,611

General and administrative expenses

1,346

Amortization

276

Interest

16 1,638

Operating profit

973

Equity income from affiliates

165

Other income

52 217

Income before income taxes and extraordinary items

1,190

Income taxes: Current

584

Future

59 643

Income before extraordinary items

547

Extraordinary items

—

Net income for year

$547

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ACR Ltd. Balance Sheets As at December 31 2008

2007

Assets Current assets: Cash

$693

Trade accounts receivable

2,107

3,464

Income taxes recoverable

—

506

Inventories

810

410

Prepaid expenses

3,671

4,479

405

203

1,532

1,632

$5,608

$6,314

—

$1,291

Accounts payable and accrued liabilities

398

497

Income taxes payable

282

Liability for future income taxes

763

1,886

825

1,908

2,268

3,895

3,275

Investments in affiliated companies Machinery and equipment

—

Liabilities Current liabilities: Bank indebtedness

Future income tax liability

Shareholders’ Equity Share capital Capital contributed on issue of warrants Retained earnings Excess of appraised value of fixed 467 .

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assets over amortized cost Less: Cost of shares purchased

1,175

1,307

7,418

6,930

2,635

2,524

4,783

4,406

$5,608

$6,314

Required a.

What is the amount of net accruals included in ACR Ltd.’s year 2008 net income?

Use the information in the income statement and balance sheets of ACR Ltd. to calculate the various individual accruals and reconcile to the net total in part a.

Upon comparing operating cash flow and net income, we see that the accruals have substantially lowered the reported income for the year. Give reasons why management may want to manage income downwards in this manner.

11A-3. A way to manage earnings is to manipulate the point in the operating cycle at which revenue is regarded as earned. An article entitled “Bausch & Lomb Posts 4th-Quarter Loss, Says SEC Has Begun Accounting Probe” appeared in The Wall Street Journal on January 26, 1995. The article reported on questions raised by the SEC about Bausch & Lomb Inc.’s premature recording of revenue from products shipped to distributors in 1993. “Bausch & Lomb oversupplied distributors with contact lenses and sunglasses at the end of 1993 through an aggressive marketing plan, and was forced to buy back a large portion of the inventory [in 1994] when consumer demand didn’t meet expectations.” The oversupply amounted to around $10 million, which Bausch & Lomb claimed was not “material.” In addition, the article points out that in the fourth quarter of 1994 Bausch & Lomb had incurred $20 million in “one-time expenses,” which included expenses from “previously announced staff cuts of about 2,000.” Also, in the fourth quarter Bausch & Lomb took a $75 million charge in its oral-care division in order “to reduce unamortized goodwill 468 .

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that it recorded when Bausch & Lomb bought the business in 1988.” Many analysts are saying that Bausch & Lomb are looking to sell the oral-care division, and this reduction of unamortized goodwill will make the division look better. Required a.

What earnings management policy did Bausch & Lomb appear to be following in 1993?

Evaluate revenue recognition policy as an earnings management device.

The article refers to a $20 million writeoff in 1994 relating to staff cuts, and another $75 million writeoff in Bausch & Lomb’s oral-care division. What earnings management strategy does the firm appear to have followed in 1994? Why?

Do Bausch & Lomb’s 1993 and 1994 earnings management strategies suggest that its management does not accept efficient securities market theory? Explain why or why not.

th 11A-4. Note: The 5 and subsequent editions of this text have removed discussion of push-

down accounting. Earnings management extends into the realm of new share offerings (IPOs), since the prospectus for a new offering includes current and recent financial statements. An article entitled “RJR Nabisco’s Use of Accounting Technique Dealing with Goodwill Is Getting a Hard Look,” which appeared in The Wall Street Journal on April 8, 1993, describes some earnings management considerations surrounding a $1.5 billion new share offering of Nabisco, a food subsidiary of RJR Nabisco Holdings. According to the article, the parent, RJR Nabisco Holdings, has substantial goodwill on its books arising from its acquisition of Nabisco, which is being amortized at a rate of $607 million annually (at the time, in the United States, APB 17 required that goodwill from acquisitions be amortized over a period of up to 40 years). However, this

469 .

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goodwill amortization appears only on the books of the parent—not on those of Nabisco. According to the article, “What RJR is doing is presenting Nabisco’s annual earnings without the burden of $206 million of 1992 ‘goodwill,’ leaving this earnings-depressing item with the parent company instead.” This resulted in Nabisco increasing its 1992 after-tax profit from $179 million to $345 million or from 48 cents a share to 93 cents a share. The article goes on to state “Nabisco executives indicated the food company could generate 1993 earnings of as much as $1.30 a share. That earnings level might justify the proposed selling price of $17 to $19 a share for the new Nabisco shares, analysts say.” The article questions whether RJR is managing the reported net income of its Nabisco subsidiary by not “pushing down” goodwill to Nabisco.

Required a.

What pattern of earnings management is RJR following? Why?

Without considering any strategic issues surrounding the pricing of the new shares, do you think that goodwill should be pushed down to the subsidiary company?

Do you think the strategy of not pushing down the goodwill will be successful in raising the issue price of the new shares? Explain why or why not.

11A-5 The potentially serious consequences of bad earnings management are illustrated by the case of Atlas Cold Storage Income Trust, which operates a system of refrigerated warehouses across Canada and the United States. During June 2004, the Ontario Securities Commission filed quasi-criminal charges under the Ontario Securities Act against four senior officials of the company, including its CEO. The company itself was

470 .

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not charged because it cooperated with the investigation and took steps to remedy the problems. The OSC charged that during 2001–2003, Atlas had engaged in several types of financial statement manipulations. One tactic was to capitalize certain costs that, according to GAAP, should have been charged to expense. Another involved deferring recognition of a large customer claim for damaged goods from 2001, where it belonged, to 2002. A third tactic was to disguise breaches of debt covenants by a subsidiary company by advancing money to the subsidiary at financial statement dates. These advances were repaid shortly thereafter. According to revised financial statements filed by the company, net income was originally reported too high by $5.2 million for 2001 and $32.4 million for 2002. The company also faced a class-action lawsuit by investors. In 2008, this lawsuit was settled, without admission of liability, by a deposit from Atlas of $39.5 million into a fund to reimburse investor losses. Required a.

Evaluate the short-run (i.e., one year) and long-run effectiveness of capitalizing expenses as an earnings management device.

The motivation for some of the claimed manipulations was apparently to meet earnings targets. Why is it important to managers to meet earnings targets? Use concepts of market efficiency and investor rationality in your answer.

11A-6 Spanish banks largely avoided the consequences of the 2007–2008 meltdown in the markets for ABSs, CDOs, ABCPs, etc. A possible reason was “dynamic provisioning,” under which, in addition to provisions for loan losses on loans currently outstanding, Spanish banks recorded additional provisions when loans were growing strongly, drawing on them to reduce loan loss provisions during periods of lending contraction. The idea is that over the course of a business cycle, the loan loss overprovisions early in the cycle will be balanced out by underprovisions later on, with no net effect on total earnings over the cycle. Thus, when financial instruments markets melted down and 471 .

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lending contracted in 2007–2008, Spanish banks did not need to make as large provisions for losses as many other banks, since some of these losses were absorbed by overprovisions in earlier boom years. As a result, Spanish banks did not run into capital adequacy shortfalls to the same extent as banks in other countries. Dynamic provisioning is a form of earnings management, in which loan losses are smoothed over the course of a business cycle. This is contrary to IAS 39 (now replaced by IFRS 9), under which financial asset writedowns are based only on balances outstanding as at the financial statement date. Required a.

Evaluate the relevance and reliability of dynamic provisioning.

Does dynamic provisioning constitute good or bad earnings management?

Explain. c.

Assuming that manager compensation is based on both net income after

dynamic provisioning and share price performance, how do you think bank management would react to an accounting standard requiring dynamic provisioning?

11A-7 On October 3, 2007, Deutsche Bank AG announced that it would record a writedown of EUR 2.2 billion. Most of the writedown applied to its investments in asset-backed securities and related financial instruments, following from the August meltdown of the market for these investments. This writedown materially reduced third quarter, 2007, earnings. At the same time, the Deutsche Bank CEO reaffirmed the company’s previous earnings guidance for 2008, which was for a profit of EUR 8.4 billion. However, he qualified this forecast with the comment that this assumed “normally functioning markets.” Comments appeared in the financial press, following these announcements, about the difficulties faced by Deutsche Bank in determining the new fair value of these writtendown investments, since market values were not readily available. Some comments suggested the possibility that the company was taking a bath, thereby creating a “cookie jar” that could be used to augment future earnings. Other commentators were 472 .

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concerned that the writedowns may have been understated, rather than overstated, so as to disguise losses, and that further writedowns would likely follow. The company assured investors, however, that it had used “a rigorous process applying appropriate accounting principles.” In the face of these events, the share price of Deutsche Bank rose 2.1% on October 3, compared with a rise of about 0.6% on that day for the Dow Jones Stoxx European banking index. On October 4, Deutsche Bank shares closed unchanged, compared with a 0.96 increase in the banking index. Required a.

Give reasons why Deutsche Bank’s share price rose on October 3.

Give reasons why Deutsche Bank may want to take a bath.

Give reasons why Deutsche Bank may want to understate its writedown.

You are an auditor of Deutsche Bank. Prior to the writedown, suppose the bank

suggested that the investments in question be reclassified from held-for-trading (their present classification under IAS 39) to held-to-maturity. What is your reaction to this suggestion? Explain.

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Suggested Solutions to Additional Problems 11A-1 a.

The 3.1% fall could have been due to a fall in the stock market index (i.e.,

economy-wide risk) on that day. (EHS investigated this possibility, and concluded that the fall was not “the outcome of general macroeconomic events.”) The fall was likely due to investors anticipating the announcement and “fearing the worst.” If so, the subsequent rise could have been because the actual loan loss provision turned out to be less than the market had expected. However, this does not seem to explain why the subsequent share price increase was so high–much greater than the 3.1% drop. The most likely reason for the initial fall is that the announcement was made quite late in the day and even rational investors did not have time to analyze the possible reasons underlying the forthcoming loan loss reserve announcement. They then sold quickly to protect themselves in case the announcement turned out to be bad news. Over the next 2 days, however, it became apparent that the loan loss provision was a signal that Citicorp had a strategy to deal with its LDC loan problems. Consequently, the bank’s share price rebounded by more than the initial decline. b.

The most likely reason follows from part a, namely that Citibank’s

announcement was taken by the market to indicate that all exposed banks were taking steps to deal with the problem. That is, the ”good news” from Citibank carried over. However, the less exposed a bank was, the less it would be affected by the good news--it had less to lose in LDC loans in the first place, so information suggesting that it was taking steps to deal with the problem would have a smaller effect on its share price. Thus the most-exposed bank (Citibank) enjoyed the greatest share price increase (10.1% - 3.1% = 7%), followed by the 11 other exposed money-center banks (1.14%) and the 34 least-exposed other banks (0.54%). The reason the return is negative for these latter banks is likely because the good news was not good enough to outweigh the losses from writeoffs per se.

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The same reasons as for part a apply here. In addition, the Bank of

Boston’s capital adequacy ratio was still well above the regulatory minimum, even after its $200 million writeoff. This seems to have been interpreted by the market as an indication of the bank’s financial strength. d.

The answer seems to lie in the fact that the Bank of Boston, in addition to

increasing its loan loss provision, actually wrote off $200 million of LDC debt, thereby taking a “hit” to its capital adequacy ratio. The market apparently interpreted this as an indication that actual writeoffs were generally needed, but that other banks were reluctant to do this, creating fears that these other banks were concerned about their own capital adequacy ratios, or they would have recorded writeoffs too. This argument is consistent with the negative returns for all sample banks around December 15. It is also consistent with the much larger negative abnormal returns for the money-center banks, which were much more exposed. 11A-2 .

Net accruals are the difference between operating cash flows and

reported net income. Here, net accruals for 2005 are $2,386 - 547 = $1,839. b.

The individual 2008 accruals of ACR Ltd. can be calculated and reconciled as

follows: Cash flow from operations

$2,386

Less: Amortization expense

$276

Future income taxes expense

Decrease in net accounts receivable

1,357

Decrease in income taxes recoverable

506

Increase in income taxes payable

248

Decrease in prepaid expenses

Increase in current liability for future 475 .

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income taxes

19 2,503 (117)

Add: Equity income from affiliates

$165

Increase in inventories

400

Decrease in accounts payable and accrued liabilities

Net income as per income statement c.

664 $ 547

Reasons why management may want to manage income downwards by means

of accruals: •

Political costs. If ACR is very large, it is very much in the public eye. It may fear political repercussions if it reports earnings that are perceived as too high.

•

Manager bonus. If it appears that ACR’s earnings for bonus purposes will be above the cap of the bonus plan, management may wish to lower reported earnings. Otherwise, bonus will be permanently lost on above-cap earnings.

•

Taxation. If firms in the United States use the LIFO inventory method for income tax purposes, they must also use LIFO in their financial statements. On a rising market, LIFO reports a lower net income than other methods, such as FIFO. The firm then reports a lower net income in order to save taxes. ACR does not indicate which inventory method it uses, however.

•

Taking a bath. The firm may want to increase the probability of high future earnings by writing assets down currently and/or providing for future costs, such as for downsizing or reorganization. This motivation may be present when a new management takes over, or when earnings are below the 476 .

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bogey of the bonus plan. In the case of ACR, however, no unusual, nonrecurring or extraordinary items appear on its income statement. Unless these are buried in larger totals, it seems this motivation does not apply to ACR in 2008. •

To communicate inside information to investors. If current year’s operations have led to higher earnings than ACR’s management thinks will persist, it may wish to manage reported earnings downwards so as to credibly inform investors of its best estimate of sustainable earnings.

11A-3 a.

Bausch & Lomb appears to have followed a policy of income maximization in

1993. b.

Bausch & Lomb appears to have used revenue recognition policy as a device

to manage annual (1993) earnings. Such a policy is reasonably effective, at least in the short-run, since revenue recognition criteria under GAAP are vague. This gives the firm some room to manoeuvre in terms of timing of when it regards revenue as earned. In particular, current earnings can be increased by recogizing revenue on excess shipments to distributors. In the longer run, however, a disadvantage of Bausch & Lomb’s early revenue recognition policy is that it involved physical shipment of product to distributors. There may be limits to distributors’ storage capacity and ability to carry the additional inventory, rendering the policy potentially quite costly. Indeed, it was this aspect of Bausch & Lomb’s 1993 policy that seemed to come back to haunt it in 1994, namely, the need for buybacks. Another longer run disadvantage of early revenue recognition is that accruals reverse. Thus, higher revenue recognized in 1993 means lower revenue in 1994. Then, even more shipments to distributors are needed in subsequent years if the policy is to be maintained. We conclude that revenue recognition policy is reasonably effective in the short run but its effectiveness decreases over the longer term. 477 .

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Bausch & Lomb appears to be taking a bath in 1994. Presumably, this is to

increase earnings in subsequent years by “clearing the decks,” possibly to make its oral-care division appear more attractive for a sale, or to “bank” earnings so as to increase the probability of substantial earnings increases in future years. d.

Arguments that Bausch & Lomb’s management does not accept securities

market efficiency depend on the extent to which its earnings management strategies are visible to investors. If these strategies are visible, there would be little point in trying to fool an efficient market. Consequently, visible earnings management strategies suggest management does not accept efficiency. At least some of the firm’s earnings management strategies are visible. These include the staff cuts and the $75 million charge in its oral care division. Visibility of other strategies, such as “stuffing the channels” in 1993 is less clear. To the extent that Bausch & Lomb felt the market would not find this strategy out, it is consistent with acceptance of efficiency. That is, management could both accept efficiency and feel that it could fool the market through lack of disclosure. However, it is also consistent with not accepting efficiency. Management may feel that even if stuffing the channels was visible, the market would still react favourably to higher reported 1993 earnings. Additional arguments can be made based on contracting theory. The bath strategy may be for bonus purposes, consistent with Healy’s findings for earnings below the bogey. Management may both accept securities market efficiency and manage earnings for contractual reasons. Bausch & Lomb management may feel that with these 1994 writeoffs behind them, the firm’s persistent earning power will be revealed, consistent with a desire to convey inside information to an efficient market. Yet another possibility may be that management is signalling to the efficient market that it has its problems in hand and has a well-worked-out strategy to deal with them.

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This argument is consistent with the findings of Liu, Ryan, and Whalen (1997) with respect to banks (see Section 11.5.2).

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RJR is following an income maximization policy with respect to Nabisco. A

possible reason is that RJR is planning a new Nabisco share offering. It seems to believe that higher reported earnings will enhance the offering price. b.

According to value relevance theory (Chapter 5), it should not matter whether

goodwill is pushed down as long as the amount is disclosed, since the efficient securities market will put the same values on shares of parent and subsidiary regardless. Certainly, the amounts involved here have been disclosed, since they are reported in the article. According to the measurement approach (Chapter 6), goodwill should be pushed down since this results in more relevant values on the books of the subsidiary. Furthermore, the value of goodwill should be reliably determined since it resulted from an arms-length acquisition transaction. Note: While it predates IAS 36 and SFAS 142, this question can also be discussed in relation to these standards. They eliminate amortization of purchased goodwill (see discussion in Section 7.11.2). Then, pushing down goodwill to Nabisco is of less immediate concern to RJR management since, even if it was pushed down, there would be no goodwill amortization and resulting lower reported earnings, on Nabisco’s books. However, purchased goodwill is subject to the impairment test under the above new standards. If goodwill on Nabisco’s books should hit the ceiling, a writedown may be required. Then, Nabisco’s reported earnings would be reduced if the goodwill had been pushed down. Consequently, RJR management may still wish to avoid this possibility, by not pushing down. Of course, if Nabisco’s goodwill should hit the ceiling, it would have to be written down on the parent’s (RJR Nabisco Holdings) consolidated financial statements, whether or not it was pushed down. c.

The answer depends on the extent of securities market efficiency. Given full

(semi-strong) efficiency, and full disclosure, the strategy should not affect the issue price. If markets are less than fully efficient, the strategy may have an impact. The 480 .

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article seems to imply less than full efficiency, for example, by implying that share prices are set by mechanical application of earnings per share ratios. Also, theory and evidence from behavioural finance (Section 6.2) suggests that investors may not be as adept at figuring out complex transactions as efficient securities market theory implies. If so, pushing down the goodwill may help investors evaluate the real value of the shares of Nabisco. 11A-5 a.

In the short-run, capitalizing expenses to manage earnings is of moderate

effectiveness. On the one hand, the reduction in current reported expenses is considerably greater than the increase in amortization, so that there is scope for a considerable increase in reported profits. Furthermore, capitalizing expenses does not reduce current operating cash flows (since they are included in the investing, not the operating, section of the funds statement). As a result, techniques that attempt to identify earnings management by estimating discretionary accruals, such as the Jones model, are less effective. On the other hand, effectiveness is reduced because capitalization of expenses is contrary to GAAP. As a result, unless the capitalizations can be concealed from the auditor, they will have to be reversed or the firm will receive a qualified audit report. The ability to conceal becomes more difficult the larger the amounts capitalized. In the longer run, the scope for increasing reported profits and the lack of effect on operating cash flows continues. However, as amounts capitalized continue to accumulate, it becomes more likely that this earnings management will be discovered. We conclude that effectiveness is only moderate in the short run and declines over time. b.

The importance of meeting earnings targets derives from securities market

efficiency and rational investor behaviour. A firm’s share price will incorporate the market’s expectations of future firm performance. Earnings targets, for example those laid down by management forecasts and/or by analysts, are an important indicator of future performance. If these targets are not met, investors’ expectations of future firm performance will fall and share price will quickly fall with them. This is likely to be the case even if earnings are just short of target, since the market will suspect that if the 481 .

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firm could not manage earnings upwards by a small additional amount, its future must be bleak and/or management is unable to predict the firm’s future operations. As a result, managers’ compensations, including the value of share holdings, ESOs, and other share price-based compensation will fall. The manager’s reputation, tenure, and the firm’s cost of capital will all be negatively affected. To avoid these consequences, managers strive to meet earnings targets. 11A-6

The answer depends on the decision horizon of investors. Investors with

a short-run horizon (e.g., one year) may not find dynamic provisioning to be relevant since current earnings are understated or overstated relative to what they would be in the absence of dynamic provisioning. This would be of particular concern to them if lack of full disclosure of the dynamic provisioning provisions prevented them from knowing the effect of these provisions on current net income. However, investors with a long decision horizon (e.g., over a business cycle) would find dynamic provisioning relevant since it would better enable them to better predict average net income, hence future firm performance, over the course of the cycle. The reliability of dynamic provisioning would be low since it is difficult to predict the timing and severity of business cycles. The provisions would thus be subject to error and possible manager bias. b.

The intent of dynamic provisioning is good earnings management, since it

attempts to report persistent earnings over the business cycle horizon. However, due to low reliability, it could easily degenerate into opportunistic (i.e., bad) earnings management. c.

The effect of dynamic provisioning would be to smooth earnings over the

business cycle. Thus, for a manager with a reasonably long decision horizon, volatility of expected future bonuses is reduced and expected utility increased. Managers with a short decision horizon would like or dislike dynamic provisioning depending on the stage of the business cycle. For example, in good times, such a 482 .

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manager would dislike the resulting reduction in annual earnings and bonus; and vice versa. Managers who wish to engage in responsible earnings management would like dynamic provisioning since it provides a vehicle for reporting persistent earnings. Managers who wish to engage in opportunistic earnings management may also like dynamic provisioning since, due to the potential for bias, it provides a vehicle to manage reported earnings. The manager’s reaction to effect of dynamic provisioning on share-based compensation would depend on his/her perception of securities market efficiency. If the manager accepts efficiency, he would anticipate a relatively smooth future stream of stock price-based compensation since the efficient market would smooth out stock price fluctuations over the business cycle, increasing expected utility of compensation. That is, the market would not overreact to lower earnings during good times and underreact during bad times. However if the manager does not accept market efficiency, he/ she would anticipate a more variable stream of stock price-based compensation, with lower utility. 11A-7 a.

Reasons why Deutsche Bank shares rose on October 3: •

Reduction of uncertainty. Given the market meltdown of asset-backed securities, the market had little idea of their fair value, hence little idea of the losses faced by firms holding these securities. The EUR 2.2 billion writedown gave investors at least a ballpark figure of Deutsche Bank’s losses. The result is to lower estimation risk and/or lower Deutsche Bank’s beta (since Deutsche Bank’s loss provides some information about losses of other banks), both of which raise stock price.

•

The amount of the writedown may have been less than the market expected.

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Cleaning house. The market may have felt that the writedown signals that Deutsche Bank has put its losses behind it and will now turn its full attention to increased future profitability.

•

Optimistic earnings forecast. The market may have felt that the CEO’s reaffirmation of Deutsche Bank’s 2008 profit forecast indicated that he felt that the company’s asset-backed securities losses were now behind it and that he felt securities markets will return to normal functioning.

Reasons why the bank may have wanted to take a bath: •

Investors feared the worst. Consequently they would not penalize Deutsche Bank unduly if the writedown was inflated.

•

Cookie Jar. Since the company reiterated its 2008 profit forecast, it would be anxious to avoid the consequences of not meeting it. Putting earnings in the bank by means of a cookie jar increases the likelihood that it will meet its forecast.

Reasons why the bank may want to understate its writedown: •

Investor unease. Investors were concerned about the consequences for the economy of major losses by financial institutions. If investor concerns led to recession, this would reduce future bank profits. High reported writedowns would increase investor concerns.

•

Regulatory concerns. As a financial institution, Deutsche Bank may have been concerned about violation of capital adequacy requirements if writedowns were sufficiently high.

•

Debt covenant hypothesis. Excessive writedowns may lead to violations of debt covenants.

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Management compensation. Managers whose bonuses are tied to earnings or stock price may fear reduced compensation if high writedowns lead to lower values of these performance measures.

Under IAS 39 (as it presently exists), reclassification would lead to valuing the

reclassified securities at cost, not fair value. If so, a writedown may be avoided. While held-to-maturity securities are subject to an impairment test, the test is based on expected future cash flows, not on fair value. Management may feel that it can justify no impairment writedown if it argues that future discounted cash flows are at least equal to cost. You would object to this suggestion, for the following reasons: •

Reclassification suggests opportunistic behaviour by management. Accepting such behaviour violates ethical behaviour and professional responsibility.

•

If the reclassification becomes public knowledge, this will adversely affect management’s reputation and market value, and could lead to legal liabilities and penalties for the firm and its managers.

•

Once reclassified, the securities could not be sold until maturity. Situations could arise such that it would be desirable to sell prior to maturity, but, if sold, the consequences under IAS 39 would be that use of the held-to-maturity classification is denied for all securities for 2 years.

Note: Your ability to object is reduced following the relaxations of fair value accounting introduced by the IASB in 2008. When markets are inactive, fair value can be estimated based on the firm’s own assumptions of future cash flows from the assets/liabilities, discounted at a risk-adjusted interest rate. This may reduce the firm’s incentive to transfer the assets to held-to-maturity. Also, the relaxations specifically allow reclassification in rare circumstances. The 2007-2008 market meltdowns were regarded as such. Thus, the firm could proceed to reclassify regardless of your objections. 485 .

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Under IFRS 9, effective 2013, the firm can value financial assets on an amortized cost basis if this accords with the firm’s business model. This would further constrain you ability to object.

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CHAPTER 12 STANDARD SETTING: ECONOMIC ISSUES 12.1

Overview

12.2

Regulation of Economic Activity

12.3

Ways to Characterize Information Production

12.4

First-Best Information Production

12.5

Market Failures in the Production of Information 12.5.1 Externalities and Free-Riding 12.5.2 The Adverse Selection Problem 12.5.3 The Moral Hazard Problem 12.5.4 Unanimity

12.6

Contractual Incentives for Information Production 12.6.1 Examples of Contractual Incentives 12.6.2 The Coase Theorem

12.7

Market-Based Incentives for Information Production

12.8

A Closer Look at Market-Based Incentives 12.8.1 The Disclosure Principle 12.8.2 Empirical Disclosure Principle Research* 12.8.3 Signalling 487 .

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12.8.4 Private Information Search 12.9

Are Firms Rewarded for Superior Disclosure? 12.9.1 Theory 12.9.2 Empirical Tests of the Effects of Disclosure 12.9.3 Is Estimation Risk Diversifiable?* 12.9.4 Conclusions

12.10 Decentralized Regulation 12.11 How Much Information Is Enough? 12.12 Conclusions on Standard Setting Related to Economic Issues LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

To Not Take Regulation for Granted

This is the first of two chapters which consider the role of standard setting in mediating the fundamental problem of financial accounting theory that was defined in Section 1.10. The chapter is complex, somewhat esoteric, and comes late in the course. Consequently, I work particularly hard to “market” the chapter to the students. My minimal objectives are that they do not take the current structure of regulation in financial accounting and reporting for granted, and do not take for granted that increasing financial accounting regulation is necessarily desirable. To enhance their interest, I usually begin with a discussion of what might happen if regulation of financial reporting was eliminated, or substantially reduced, including the effects on the number of jobs in the accounting industry. I bolster the question by reference to recent instances of deregulation in other industries. To balance the discussion, I usually hand out and discuss an article and issue relating to market failure, 488 .

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such as insider trading or failure to release information, from the financial press. The assignment questions for this chapter contain examples of this type of article. The 2007-2008 market meltdowns (Section 1.3) provide a more recent source of discussion of the pros and cons of regulation. On the one hand, severe criticisms arose concerning the adequacy of regulations of the financial industry and, closer to home, those pertaining to fair value accounting. We now observe new regulations, some of which are still in process, to increase regulation of banks and trading of derivatives. We also observe aeveral new accounting standards (Sections 7.5 and 7.8), some of which back off from fair value accounting for financial instruments. Whether or not these regulations will reduce criticisms of accounting standards, and prevent recurrence of the abuses leading up to the market meltdowns, remains to be seen. 2.

To Conceptualize Ways in which Firms can Produce Information

Here, I treat information as a commodity, and draw an analogy with the production of more conventional products. The idea is to get the students to think about both the benefits and the costs of information production. Conceptually, one can then think, by analogy with conventional microeconomic analysis, about “how much” information the firm should produce. It is worth pointing out that the definition of the socially best amount of information production in the text is a strictly economic definition (see Section 12.4). The definition ignores the distribution of information. However, this question is not avoided—it forms the subject of Chapter 13. Of course, information is a very complex commodity. I discuss briefly the three ways to think about the quantity of information produced that are given in Section 12.3. 3.

To Review Incentives for Firms to Produce Information

I emphasize the important point that, to a considerable extent, firms want to produce information, without a regulator requiring them to do so. I divide these into contractual and market-based reasons. For contracting, the parties want to produce information so as to improve the efficiency of contracting. With respect to markets, the argument is 489 .

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that production of information can lower cost of capital. The empirical results outlined in Section 12.9.2 suggest that the stock market does reward and punish firms’ information production decisions. These empirical results provide encouragement that the market does reward superior information production. However, (optional Section 12.9.3) if estimation risk (a major source of how information production can lead to lower cost of capital) is diversifiable, the benefits of information production are reduced. The answer to the question of estimation risk diversifiability seems unclear at the present time. 4.

To Appreciate Sources of Market Failure in Information Production

Externalities and free riding are well-known sources of market failure, which apply to information production. I emphasise that information asymmetry also leads to market failure. It may not be correct to call this failure per se, since it is only failure if evaluated relative to a first best ideal of properly operating markets. However, the important point is that securities and managerial labour markets are not capable of completely overcoming the effects of information asymmetry and restoring first-best levels of effort and information production. As a result, incentive contracts are still needed to motivate (second best) manager effort. Nevertheless, a case can be made for regulations to control the effects of information asymmetry by fully disclosing manager compensation, controlling insider trading, and generally promoting full and timely information release. Regulations such as these improve the operation of the managerial labour market, thereby reducing the extent to which (costly) incentive contracts have to take over. 5.

To Appreciate the Extent to which Private Market Forces Limit Market Failure

For this objective, I give intuitive presentations of the disclosure principle and its limitations, and of signalling. With respect to signalling, I assign and discuss the Healy and Palepu (1993) paper (Problem 10). This paper is effective in conveying the nature of signalling costs. I then discuss with the class the signalling potential of accounting policy choice, financial forecasts, and audits, and why such signals are credible. With 490 .

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respect to accounting policy choice, one can argue, for example, that a low-type firm that chooses conservative accounting policies will incur costs of possible debt covenant violation that will not be incurred by a high-type firm. For financial forecasts in MD&A and audits I emphasize that the manager must have a choice if accounting products such as these are to have signalling potential. Thus, regulation to restrict choice, such as a requirement that all firms issue financial forecasts, reduces signalling potential. Most students have little trouble in understanding the concept of a signal. If they do have trouble, it is in understanding why a signal is credible. The reason should be emphasized when discussing signals. 6.

To Appreciate the Cost/Benefit Trade-off of Regulation

Here, I emphasize the various costs of regulation, since bodies that push for new regulations, including standard setters, rarely refer to costs thereof. Management’s objections to the costs of the Sarbanes-Oxley Act illustrate an argument that regulation can be very costly. Problem 15 of Chapter 13 considers these objections, and could be discussed at this point. If time permits, I return to the opening theme and ask again whether regulation in accounting should be decreased, or continue to increase. While it is sometimes hard to get a good discussion going, a variety of views usually emerges. Most professional accounting students, however, are understandably cautious about deregulation in their chosen career path. 7.

Decentralized Regulation

IFRS 8 and ASC 280-10 (formerly SFAS 131) relate to what I call decentralized regulation of segment reporting. This concept is also called the “management approach.” These standards contain a requirement that firms report segment information on a basis consistent with how these segments report internally for management purposes. It strikes me that this requirement illustrates a compromise between regulation and deregulation arguments. That is, it requires that segment information be disclosed, but decentralizes how to disclose it to the internal decision of management. This decentralization should increase decision usefulness to investors 491 .

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while at the same time reducing compliance costs, and even retains some signalling potential since management can reveal inside information about its internal organization by the format of its disclosure. Note that the firm may change its internal organization if it regards this information as sufficiently proprietary. If so, the firm’s internal organization is affected by financial reporting considerations, rather than vice versa. That is, decentralized regulation may have economic consequences. It is interesting to see this decentralized approach to regulation showing up in other standards, such as flexibility of MD&A disclosures (Section 3.6), designation of hedging instruments (Section 7.9.2), the fair value option (Section 7.5.3) and the concept in IFRS 9 of basing the accounting for certain financial instruments on the firm’s business model (Section 7.5.2).

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

The firm’s costs of producing information will depend on the nature of the information produced. For finer information, costs would arise from reporting extra line items in the financial statements, preparing notes to the financial statements, and reporting other supplementary information which expands disclosure within the mixed measurement model framework. For additional information, such as RRA and MD&A, costs are incurred in preparation and disclosure. These costs can be quite high, since the additional information requires numerous estimates and forecasts. In both cases, costs could also include proprietary costs arising from release of information to competitors. For example, new entrants may be attracted to the industry. For more credible information, costs would include, for example, higher fees paid to a more prestigious auditor. For signals, the cost would depend on the signal. If the firm voluntarily discloses a forecast of next year’s operations, this would be a signal that the firm is confident about its future. The costs of this signal include preparing and presenting the forecast, and the expected costs of any penalties or lawsuits against the firm if the forecast, even if made in good faith, turns out to be materially wrong. Agency costs of compensation contracts could also increase if the forecast’s effect on share price swamps the informativeness of share price about manager effort. Other signals would be the hiring of a prestigious auditor, and presenting more than the minimum amount of financial statement disclosure (the MD&A of Canadian Tire Corporation in Section 3.6.3 is an example). Here, costs include the additional auditing and disclosure costs. The benefits of information production derive from a feeling by investors that the firm is transparent, that is, it is up-front and candid in revealing information about itself. That is, information production reduces estimation risk. The benefits could 493 .

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show up in a reduction of the firm’s cost of capital. Other benefits derive from a reduction of the agency costs of contracting. For example, if a firm agrees to include debt covenants in its borrowing contracts (a form of information production), this will lower the costs of borrowing. The firm should produce information until its incremental cost of information production is equal to its incremental benefits as perceived by the firm. This amount could differ, however, from the socially best information production, due to externalities and other market failures that affect information’s social value. 2.

When a decision is internalized, the decision matters only to the person or persons making it. It is not necessary for other persons to be concerned with the decision. We saw this phenomenon in Section 9.2.2, when we considered an owner renting the firm to the manager for $51. The owner did not care about the level of effort exerted by the manager because the owner receives rent of $51 regardless of the circumstances. It is only the manager who cares because the level of effort will affect how much firm payoff can be expected after paying the rent. A similar situation applies to contracting in general. The parties to the contract, such as a debt contract, have an incentive to agree on the type of information needed to monitor contract performance, so as to minimize agency costs. The important point is that the provision for information is part of the contract. No external/third-party regulation is needed to motivate its production.

(i)

Securities market. If the manager shirks, this will result in lower firm

earnings, on average, which would adversely affect the firm’s share price and cost of capital. The manager may be fired or the firm may be the object of a takeover bid. These potential consequences will tend to reduce manager shirking. However, it is unlikely that shirking will be reduced to the point where the manager exerts a first-best effort level. Reasons include: 494 .

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There will be periods in which favourable realizations of states of nature produce high profits regardless of shirking.

•

Managers may care less about the consequences of shirking if they are close to retirement.

•

Managers may be able to disguise shirking, at least in the short run, by manipulating real variables such as R&D, by opportunistic (i.e., “bad”) earnings management, or by delaying release of bad news.

(ii) Managerial labour market. If the manager shirks, this will result in lower firm earnings, on average, which will adversely affect the manager’s reputation and the reservation utility he/she can command in future incentive contracts. Again, this can lead to being fired or the firm being the object of a takeover bid. Market forces are subject to adverse selection and moral hazard problems. That is, market forces may reduce the extent to which an incentive compensation contract is needed, but they do not eliminate the need for such contracts. Financial accounting information, or any other available information for that matter, does not provide perfect information about opportunistic manager behaviour and shirking. This is because manager effort is generally unobservable, so that managers may be able to exploit inside information for their own benefit (adverse selection problem) and disguise shirking through earnings management (moral hazard problem). 4.

Three ways that we can think about the quantity of information are: (i)

Finer information. When we think of an additional quantity of information

as finer, we mean that additional detail is supplied within the existing financial reporting framework. Thus, finer information involves the expansion or elaboration of information that is already being presented. Examples include additional financial statement line items, such as breaking down capital assets into land and buildings; presenting the allowance for doubtful accounts as a separate item rather than reporting only net accounts receivable; presenting 495 .

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interest on long-term debt separately from other interest expense, and so on. Other examples include the presentation of segment information and expanded note disclosure. In technical terms, the presentation of finer information enables the user to better discriminate between realizations of states of nature. (ii)

Additional information. This involves an expansion of the set of states of

nature that is being reported on, rather than just a refinement of the existing set. Thus, RRA financial information involves adding additional states to the existing mixed measurement model system. These additional states include values of proved reserves and rates of production. Other examples of additional information include MD&A, risk disclosures, and expanded segment information. Fair values, for example of financial assets and liabilities, impaired loans, and capital assets also represents additional information, to the extent they are not already reported under the mixed measurement model. This information can be produced either as supplementary information or in the financial statements proper. (iii)

Credibility of information. A third way to think about the quantity of

information is in terms of its credibility. Information will be viewed by the market as credible if it is known that the manager has an incentive to reveal it truthfully. The credibility of accounting information can be enhanced by means of an audit, for example. We can measure credibility by the reputation of the auditor, the type of audit engagement (statutory audit, review, compilation, write-up, etc.), the audit fees paid, the number of audit hours, and so on. Hopefully, any opportunistic reporting by the manager will be caught by the auditor. Penalties for false or misleading information also enhance credibility, since the manager then has an additional incentive to report truthfully. In addition to fines, penalties include those imposed by market forces, such as loss of reputation and lower reservation utility, as well as penalties resulting from lawsuits. The greater the penalties, and the greater the likelihood that they will be applied, the greater the credibility. 496 .

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The adverse selection problem in this context is that persons with

valuable inside information about a firm may take advantage of this information to earn profits at the expense of outside investors. They may do this by failing to release their information or acting on it before releasing it. They can then earn profits from insider trading. b.

Financial accounting information can reduce the adverse selection

problem through: •

Full disclosure of useful information in the financial statements and notes.

•

Supplementary disclosure such as MD&A and RRA.

•

Timeliness of disclosure – full disclosure will reduce the scope for insider profits to the extent the disclosure takes place soon after the inside information is acquired.

It is unlikely that financial accounting information can completely eliminate

the adverse selection, inside information problem. This would be too costly. For example, some information is proprietary (R&D, merger and takeover plans). Also, continuous disclosure of all useful information would be necessary. d.

Market forces may reduce the problem. If a firm insider is revealed to

have engaged in insider trading or other abuse of inside information, investors’ estimation risk will increase. The issuer’s cost of capital will rise and reputation will be harmed, particularly if there is media publicity. Other forces derive from regulations, such as legal penalties, regulations requiring information to be released to all parties simultaneously, and requirements for firms to make immediate public announcements of important events. Many public companies have blackout periods surrounding earnings announcement dates, during which employees are not allowed to trade in 497 .

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company stock. See the study of Jagolinzer, Larcker, and Taylor (2011) in Section 4.6.1. 6.

Managers may withhold bad news: •

To conceal evidence of shirking, if the bad news results from low manager effort.

•

To delay a fall in share price, which would increase cost of capital and possibly affect manager compensation.

•

To enable insider trading profits.

•

To postpone damage to reputation.

The disclosure principle will motivate the manager to report bad news if

the following conditions hold: •

The information can be ranked from good to bad in terms of its implications for firm value.

•

Investors know that the manager has the information.

•

There is no cost to the firm of releasing the information.

•

Market forces and/or penalties ensure that the information released is truthful (i.e., credible).

Then, the market will interpret failure to disclose as indicating the worst possible information. To avoid the resulting impact on share price and manager reputation, all but the lowest-type manager will disclose. If one or more of the above requirements is violated, the disclosure principle may not completely eliminate the withholding of bad news. This will be the case when: •

The information is proprietary, so that there is a cost to disclosure. Then, there is a threshold level of disclosure. If the news is 498 .

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sufficiently bad that it is below the threshold it will not be released. The market cannot penalize the firm’s share price because it does not know if the news is the worst possible or because it is not the worst possible but is below the threshold (Verrecchia (1983)). •

Information, such as a financial forecast, may affect the informativeness of variables used for contracting (e.g., share price or covenant ratios).If release of the information imposes sufficiently high contracting costs on the firm (e.g., effect of financial forecasts on share price may be so great that they swamp the effects of the manager’s effort on share price, reducing the efficiency of the compensation contract), the firm is better off not to disclose forecasts (Dye (1985)).

•

If the market is not sure whether the manager has the information, there is a threshold below which the news will not be released, even though it is non-proprietary (and thus no direct costs to the firm of disclosure). The motivation to release non-proprietary information arises from its effect on firm value (Pae, 2005).

•

When GAAP quality is not too high, information that goes beyond mandated information disclosure will only be disclosed voluntarily if it exceeds a threshold (Einhorn, 2005).

•

If release of information may trigger the entry of competitors, the firm may only disclose a range within which the news lies. In this sense, disclosure is not truthful (Newman and Sansing (1993)).

•

When the firm is unsure of investor reaction (Suijs, (2007).

We may conclude that while the disclosure principle has the potential to motivate full release of bad news, in practice it is only partially effective due to the number of scenarios where it breaks down.

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Apple’s share price fell because of the executives’ refusal to answer. Investors knew how important Steve Jobs’ was to the success of Apple, and must have felt that the executives had inside information about his health. According to the disclosure principle, their refusal to answer led investors to believe that Mr. Jobs’ health was poor, which would threaten the company’s future. Share price fell in response to these increased concerns.

The adverse selection problem is a source of market failure in the production of information since persons who are willing to take advantage of inside information may be attracted to a career in management. They can then exploit their information advantage by withholding, or at least delaying, the release of good or bad news. This creates opportunities for insider trading and, in the case of bad news, damage to the manager’s reputation and compensation. Market failure results because useful information is withheld from the investing public.

The moral hazard problem is a source of market failure since managers may shirk on effort and cover up the resulting lower profits by opportunistic earnings management and poor disclosure. The resulting failure of manager reputation and firm share price to reflect the impact of shirking is a market failure in the production of information.

The market declined because the announcements of lower sales and

profits contained market-wide information. If sales and profits were lower for these two large and diverse firms, this suggests that many other firms will also suffer from reduced business activity. As investors bid down the share prices of Coca-Cola and Xilinx (which in itself would lower the index somewhat), the share prices of all other firms deemed to be affected by this reduced activity also declined, increasing the index decline. b.

This episode illustrates a market failure because of the problem of

externalities. The information released by Coca-Cola and Xilinx about their own prospects also contained implicit information about the prospects of other firms. The 2 companies receive no reward for this economy-wide information, 500 .

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consequently there is no incentive for them to release more than a minimum disclosure. For example, perhaps more timely release, more information about why they felt sales and profits will decline, having their auditors attest to the information, and/or breaking the sales and profits down by company line of business or division, would have helped the market to better assess the extent to which other companies would be affected. 10.

Possible signals include: • Direct disclosure of Patten’s credit granting and collection procedures, so as to inform the market of their integrity. Direct disclosure should be a credible signal here, since management would be foolish to overly expose itself to penalties such as loss of reputation and legal liability by disclosing incorrect information at such a critical time. • Management could change the firm’s financial structure, by raising private financing and/or securitizing receivable without recourse and selling to a financial institution. When there are only a few parties involved in a contract they can agree among themselves what information to provide (internalization). This signal is credible because self-interest by the parties involved will reassure the market that amounts received by Patten represent fair value. • Patten could engage in a hedging strategy. Then, credit losses on accounts receivable would be offset by gains on the hedging instruments. Such a policy would be prohibitively expensive if large credit losses were anticipated by the hedge counterparty. Consequently, it is a credible signal. • Management could increase its holdings of Patten shares. This is a credible signal since management would be foolish to acquire shares if they knew the accounts were seriously undervalued.

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• Management could declare a dividend or increase its current dividend. This policy would be foolish if management felt that it was facing serious credit losses. • Management could issue a financial forecast, which would include for anticipated credit losses. Since a forecast is public information, management would be foolish to issue a forecast that it expected would not be attained. b.

Any signal could be recommended, since all are credible. However, they

differ in their costs. Presumably, the lowest cost signal should be recommended, including proprietary costs. Arguments for and against specific signals include: • Direct disclosure of credit policies reveals proprietary information about Patten’s credit-granting procedures. These policies must be effective if anticipated credit losses are so low. Thus, this information could be of considerable use to competitors. • Raising additional capital and/or selling accounts receivable should incur low proprietary costs since they involve private transactions. While the other parties involved would conduct due diligence, they need not publicly reveal the results of their findings about Patten’s credit granting procedures and financial condition. • A hedging strategy would also protect proprietary information. Such a strategy would incur costs. However, these costs should be low given that Patten’s net accounts receivable are properly stated. •

Management purchases of Patten shares would require a cash outlay by management. However, the market would react favourably since increased share holdings loads additional risk on management, thereby increasing their incentive to work hard as well as giving them a longer-run perspective in operating the firm.

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• Declaring a dividend incurs a cash outflow by Patten. Also, a dividend may create suspicion in the market that the firm does not have profitable internal capital projects. • A financial forecast may create substantial costs for Patten and its management if some unfortunate state realization causes the forecast not to be met. It also creates incentives for management to adopt short-run operating strategies (e.g., cut advertising) and/or to engage in earnings management in order to meet the forecast. 11.

Other suggested reasons for the decline in Canadian Superior’s share

price: • The disclosure principle. The CEO’s refusal to answer questions may have led investors to conclude he had something to hide. • The sale of $4.3 million of his shareholdings by the CEO. This sale took place in the preceding January. The market should have largely reacted to it then. However, the March announcement may have suggested to the market that this insider sale was more ominous than it had perceived at the time. If so, a further share price decline would be expected. • Lawsuits. Concern about unfavourable outcome of the class action lawsuits would lead to a share price decline. b.

The CEO’s sale of stock in January, 2004, suggests the adverse

selection problem, leading to insider trading. The adverse selection problem occurs when an individual exploits his/her information advantage over other persons. Here, a likely explanation of the January stock sale is that the Canadian Superior CEO had inside information about El Paso’s intention to pull out of the project. Sale of shares before the market became aware of this intention constitutes exploitation of this information at the expense of outside investors.

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The effect would be to decrease share prices of all Canadian oil and gas

companies. This is an example of an externality. That is, share prices of other firms are affected by the actions of one firm. Share prices of all firms are affected because of a pooling effect, which takes place when investors are unable to discriminate between high and low-type firms. In effect, oil and gas shares could be viewed (mildly) as lemons, subject to considerable estimation risk. As a result, investors feel that the market for oil and gas shares is not a level playing field due to the large amount of inside information in the exploration for oil and gas and the apparent willingness of at least some insiders to exploit this information. Consequently, investors will withdraw from the market or reduce the amount they are willing to pay for all oil and gas shares. d.

Possible signals include: •

Obtain a new partner. A new partner will conduct due diligence about Canadian Superior’s prospects before investing. This will credibly signal Canadian Superior’s willingness to subject itself to the investigations conducted by the potential investors/partners, since it would not be rational to submit to such an investigation if the company believed the well’s prospects were poor.

•

Raise private financing and complete the well without another partner. This is a credible signal since it would not be rational to raise private financing if the well’s prospects are poor, particularly since any private financer would conduct due diligence before investing.

•

Issue public debt, as a signal that management believes that the probability of the debtholders taking over the firm in the future is low. Management would not be rational to issue public debt if it felt the well’s prospects were poor. 504 .

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Management could increase its shareholdings, or amend the firm’s compensation plan to require more share holdings by senior officers. Increased shareholdings would not be rational if management was concerned about future firm performance and prospects.

•

Adopt more conservative accounting policies. This will signal that future earnings can stand resulting downwards pressure. It would not be rational to adopt conservative policies if Canadian Superior management believed this would decrease any earnings-based bonuses or increase the probability of future debt covenant violation.

•

Hire a prestigious auditor. This signal may not be as effective as others since the auditor may not be experienced in auditing technical details of oil and gas exploration. However, the auditor may be able to offer reporting systems advice and implementation, to reduce the likelihood of future abuses of inside information.

•

Increase dividends and/ or undertake a stock buyback. These signals may not be effective because they could also be consistent with the company having little use for its cash in its own operations.

12.

The executive share purchase conveyed favourable inside information

about the future prospects of the company. Yes, the purchase constituted a credible signal at the time, as evidenced by the strong market response. Investors believed that it would not be rational for the Imax executives to buy these shares unless they believed the company’s future prospects were favourable. b.

The market failures are adverse selection and moral hazard. It seems that

despite their 2004 share purchases, Imax managers adopted accounting policies to overstate earnings, thereby compromising the interests of debtholders and shareholders (adverse selection). By overstating earnings, management may 505 .

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have also been attempting to cover up shirking (moral hazard). These policies constitute market failures because information about actual profitability was retained as inside information, resulting in the overstatement of Imax share price for several years. c.

Reasons why management bought shares •

They may have felt that Imax shares were undervalued by the market in 2004. The earnings management that took place during this time could be interpreted as an attempt to report what management felt was Imax’s persistent earning power.

•

Management may have been low type (i.e., they expected that future firm prospects were unfavourable) but were willing to pay the extra cost to signal high type. Perhaps they had plans to sell the shares later as share price rose due to the earnings management and consequent higher reported profits. Perhaps higher share price would increase their compensation.

•

Management may have wanted to increase its motivation to work hard, to pull the firm out of deteriorating operating performance. Increased share holdings would supply additional motivation.

•

Management may not have believed in securities market efficiency, feeling instead that the market would not have discovered their opportunistic revenue recognition and capitalization policies.

13.

The implied market failure is one of insider trading, a version of the

adverse selection problem of information asymmetry. b.

Investors will perceive greater estimation risk with respect to Newbridge.

The following effects would be expected:

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Some investors will withdraw from the market, since they feel that it Is not a level playing field, hence that there is little chance of earning a return on any investments.

•

Investors will bid down the price of Newbridge’s shares. The failure to meet current earnings expectations will result in lower demand for its shares as investors revise downwards their future earnings expectations. This effect will be increased as investors realize the insider trading reveals inside information about expectations of future profitability by Newbridge’s management.

•

The liquidity of trading in Newbridge’s shares will fall. This is due to two effects. First, as investors depart the market for Newbridge’s shares, depth falls. Second, the bid-ask spread rises as investors perceive greater adverse selection with respect to Newbridge insiders, due to insider stock sales prior to a disappointing earnings report.

Possible signals include: •

Raise private financing. Private capital suppliers will conduct due diligence about future firm prospects before investing. This will signal Newbridge’s willingness to subject itself to the investigations conducted by the lenders without directly releasing proprietary information about future firm prospects.

•

Issue public debt, as a signal that management believes that the probability of the debtholders taking over the firm in the future is low.

•

Management could increase their shareholdings. This would, in effect, reverse the earlier insider sales. Increased shareholdings would not be rational (i.e., more costly) if management was concerned about future firm performance. 507 .

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Engage a higher quality auditor, either by changing auditors or by

•

extending the scope of the existing audit. •

Raise the dividend. This would not be rational if management was worried that future earnings could not be sustained at a level to support the higher dividend.

•

Adopt more conservative accounting policies. This will signal that future earnings can stand resulting downwards pressure. It would not be rational to adopt conservative policies if management believed this would increase the likelihood of even lower profits, or losses. Conservative policies could decrease their earnings-based bonuses or increase the probability of future covenant violation.

.14.

Reasons to voluntarily expense ESOs: •

Signal. The bank may have wished to credibly signal its expectation of increased future profits and/or the low persistence of its problems with loan losses. If it expected its future profitability to be low, it would not be rational to further force down profits by expensing ESOs. Lower profits could affect share price, executive reputation and compensation, debt covenants and, for a financial institution, capital adequacy ratios.

•

Low usage of ESOs. The bank may have reduced its usage of ESOs following the financial reporting scandals of the early 2000s, where it appeared that increasing the value of ESOs was a contributing force behind opportunistic manipulation of financial statements. To the extent that ESO use is low, the effect of expensing on reported profits is low.

•

Commitment to openness and transparency in financial reporting. Given the impact on investor confidence of accounting scandals at the time, such as Enron and WorldCom, which affected share 508 .

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prices of all firms, TD may have felt that voluntary expensing of ESOs would help to improve its reputation for transparency and full disclosure, thereby reducing estimation risk, increasing public confidence and, presumably, increasing its share price. •

Anticipation of new standard. TD may have felt that it was only a matter of time until ESO expensing became part of GAAP, so it might as well start now.

Costs of a standard requiring ESOs to be expensed: •

Out-of-pocket costs. All firms would have to develop the ability and data needed to estimate ESO fair value, or hire experts to do it for them. Costs would include estimating the parameters of Black/Scholes or other valuation model, and analyzing past exercise behaviour so as to determine a distribution of times to exercise.

•

Loss of ability to signal. Firms that may wish to signal future expected profitability, transparency, and a commitment to full disclosure would not be able to do this via voluntary ESO expensing.

•

Lower reliability. To the extent that estimates of ESO cost are unreliable, reported net income will be less reliable relative to its reliability if ESO cost is reported in the notes.

•

Compensation contract efficiency. To the extent that expensing ESOs causes firms to reduce their usage, and to the extent that ESOs are an efficient compensation device, firms will have to substitute other, possibly less efficient, types of compensation to motivate performance. This would increase compensation and/or agency costs.

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Note: A counterargument is that ESOs were not an efficient compensation device, since they often seem to have motivated dysfunctional manager effort rather than increased effort—see benefits below. Benefits of a standard requiring ESOs to be expensed: •

Greater relevance. Expensing of ESOs increases the relevance of financial reporting, since lower reported profits anticipate lower per share dividends. Future dividends per share will be lower to the extent there is dilution of shareholders” interests from issuing shares at less than market value.

•

More efficient compensation contracts. Firms may reduce their usage of ESOs since it would now be necessary to record their estimated cost as an expense. To the extent that ESOs encourage dysfunctional, short run, manager behaviour, substitution of other more efficient compensation devices, such as restricted stock, will increase productive manager effort and lower compensation costs.

•

Level playing field and lower estimation risk. Investors will have greater confidence in financial reporting to the extent they perceive standard setters responding to past abuses of ESOs by requiring all firms to report their cost.

•

Investors not fully rational on average and securities markets less than fully efficient. To the extent they are not fully rational, investors may not notice ESO expense disclosure in the notes (e.g., limited attention). Since ESOs are a valid expense, they may thus overestimate firm profitability, leading to overstated share price. They are more likely to take notice of the expense if it is included in the financial statements proper. This will reduce the cost of any bad decisions such investors may make.

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Tom Jones will shirk more as a majority shareholder because prior to

going public he bore all the costs (reduction of firm value due to shirking) himself as the owner-manager and suffered the loss in profits alone. That is, the effects of shirking were internalized. Subsequent to the new share issue, he will not bear all the costs – the majority shareholders will bear their proportionate share. Thus, shirking costs Tom Jones less after going public, so, other things equal, he will engage in more of it. Yes, the amount received for the new share issue will be affected. Potential investors will be aware of Tom’s increased incentive to shirk after the share issue and will bid down the amount they are willing to pay for the new issue by their share of expected costs of shirking. b.

Steps that Tom could take to convince shareholders that he will not

engage in excessive shirking: •

Tom could hire an auditor, or increase the work done by the current auditor. This will increase the credibility of future reported profits, and help ensure that the effects of shirking, including excessive perquisite consumption and lower profits, are not hidden by earnings management.

•

Tom could increase the proportion of his compensation that depends on earnings and share price performance, to increase alignment with the new shareholders’ interests.

•

Tom could improve disclosure, so as to signal a commitment to fully inform outsiders about firm performance and prospects. For example, he could voluntarily issue a forecast of future profits, so as to credibly inform the new shareholders of his expected level of future earnings.

16.

Firms can increase the liquidity of their shares by the following policies: •

Voluntary release of information. According to Merton (1987), voluntary information release increases the number of investors who become familiar with the firm. An increased number of investors in the 511 .

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market for the firm’s shares increases market depth, thereby increasing liquidity. •

Full disclosure. According to Diamond and Verrecchia (1991), high quality disclosure reduces information asymmetry. This reduces estimation risk and the bid-ask spread, thereby facilitating trading in the firm’s shares. Empirical evidence consistent with this prediction is reported by Welker (1995).

•

Increase reporting credibility. Increased credibility of reporting can be attained by increasing audit quality. Increased credibility increases the willingness of investors to buy the firm’s shares by decreasing estimation risk, with resulting decrease in bid-ask spread. Estimation risk and bid-ask spread decreases because high audit quality reduce Investor concerns about adverse selection and moral hazard.

•

Increase financial reporting quality, increasing the amount of firmspecific information relative to economy-wide information in share price. This will reduce the stock’s synchronicity, thereby reducing its beta. This will increase demand for the firm’s shares, thereby increasing depth and share price.

Costs of higher quality reporting include: •

Out-of-pocket costs to disclose, such as costs of printing, web page design and operation, news conferences and news releases.

•

Higher audit costs

•

Proprietary costs, such as release of plans, projections, new inventions, potential acquisitions. Release of proprietary information may adversely affect future cash flows.

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Legal costs. To the extent the increased reporting quality consists of forward-looking information, failure to meet the disclosed targets may result in litigation and legal costs.

•

To the extent increased disclosure increases share price, earnings, and manager reputation, the firm may have to increase manager compensation in future, due to higher manager reservation utility.

17.

No. Holding the books open past period end and backdating contracts

both misstate accruals. Since accruals reverse, the revenue misstatements would cancel out over a period of years. b.

No. The revenue misstatements were fraud, not a result of

misinterpretation or misuse of an accounting standard. Holding the books open and backdating contracts could occur with any revenue recognition standard short of waiting until cash was collected. Even then, holding the books open would increase current cash revenue. c.

Reasons why a manager would overstate current period revenue: •

Compensation Contracts. The manager may wish to increase bonus currently, to the extent bonus depends on reported net income. Even though accruals reverse, and reported net income will eventually decrease in future by the amount of current revenue overstatement, bonus received currently has greater present value and utility to the manager than bonus received later.

•

Debt contracts. To the extent the company is concerned about debt covenant violation, increasing net income currently will help to avoid debt covenant violation, or at least delay violation.

• To meet investors’ earnings expectations. Company share price, and manager reputation, suffer greatly when earnings expectations are not met. 513 .

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• To increase the “top line” of the income statement. Growing companies may wish to convince the market of their future earnings potential by reporting high and growing revenues. • To smooth earnings. Mr. Kumar may have felt that low current earnings were temporary, and that increased future business would enable the reversal of the premature revenue recognition to be covered up. d.

The most likely source of market failure is adverse selection. By

keeping information about these revenue manipulations inside (at least until discovery in 2002), Mr. Kumar postponed the negative consequences that would have resulted from a failure to meet earnings targets. Given Mr. Kumar’s brilliance and hard work, it seems unlikely that covering up shirking (a moral hazard problem) is a source of market failure here. With respect to the operation of securities markets, they would operate less well. Investors would increase their concerns that if a fraud such as this could occur in one firm, it could occur in others. In effect, fear of “lemons” becomes greater (i.e., pooling). Thus, the increase in estimation risk would spread to all firms. This would increase firms’ costs of capital, make it more difficult for new firms to enter the market, and reduce the efficiency of capital allocation in the economy. 18.

Well-manager firms are likely to prepare quarterly forecasts for internal

use. Investors will know this. According to the disclosure principle, if the firm does not release its forecasts, investors will assume the worst; namely that the forecast is bad news. Share price will thus fall and the manager’s reputation will suffer. To prevent this, all but the firms with the worst forecasts will release them. b.

Costs to firms that issue quarterly earnings forecasts: •

Direct costs of preparing the forecast. However, these costs are likely to be incurred regardless of discontinuance, to the extent the firm forecasts for internal use. 514 .

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Earnings forecasts may reveal proprietary information of value to competitors, since they convey management’s expectations about future operations.

•

Issuance of quarterly earnings forecasts may lead to a short-term manager decision horizon whereby longer-term activities are sacrificed in order to meet the short-term earnings objectives. Examples include cutting of R&D and postponing capital expenditures.

•

Possible lawsuits if earnings targets are not met.

•

Managers may engage in opportunistic earnings management in order to meet earnings targets. This will harm the firm through lower share price (and the manager through lower reputation) when the earnings management is discovered.

It is unclear whether poor share returns around the date of the stopping

announcement are consistent with the authors’ findings. The firm is losing longer-term investors. This suggests that these investors are concerned about longer-term performance. Also, poor share returns and difficulties in meeting analyst earnings forecasts leading up to the stopping announcement suggest that the firm is performing poorly. Given this past history of publicly available bad news, an efficient securities market should have already incorporated an expectation of poor future performance into the stopping firms’ share prices, in which case the authors’ finding of negative share returns around the announcement date is not consistent with their other findings. However, the efficient market may not have been completely certain of poor future firm performance, and interpreted the stopping as additional information which confirmed its suspicions. This argument follows from the models of Brav 515 .

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and Heaton (2002) and Lo (2004), (Section 6.5.1) who argue that rational investors will not fully react to financial statement information right away, but will only partially react and watch for confirming or disconfirming news later. If so, negative share returns are consistent with the authors’ other findings that suggest firms discontinue forecasting because of bad news. Alternatively, if the securities market is not efficient due to behaviourially biased investors, it may not have noticed the prior bad news, or may not have fully realized its implications for future performance. The fact of the stopping announcement could be sufficient to cause even behaviourially biased investors to realize that poor performance was coming. Thus, inefficient securities markets could be consistent with the negative share returns, consistent with the authors’ other findings. A reasonable conclusion is that the extent to which the authors’ other findings are consistent with negative share returns around the announcement date is unclear. d.

Investors must know that management has earnings forecast information,

since this was released in the past and presumably would be continued for internal purposes. Consequently, the disclosure principle must have failed due to costs of disclosure, outlined in part b. According to Verrecchia (1893), disclosure costs create a threshold. To be released voluntarily, information must be sufficiently good news that it exceeds the threshold. In view of the high costs of failing to meet earnings forecasts, management may have concluded that issuing quarterly forecasts when poor future performance is expected would incur proprietary costs, and these costs would exceed the threshold. While forecasts are generally regarded as non-proprietary information, quarterly forecasts could incur proprietary costs if, as noted in part b, they convey management’s expectations about future operations and/or lead to excessive management concentration on short-term operations at the expense of the firm’s longer term goals. 516 .

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Reasons for the fall in GE’s share price: •

Systematic risk. Because of the U.S. recession of the early 2000s, the whole market fell, dragging GE’s share price with it.

•

Recession. The market may have been concerned that GE would be particularly affected by recession following from the stock market collapse, due to its manufacturing operations such as industrial and medical equipment. GE’s diversification across many different activities reduces the force of this argument, however.

•

Estimation risk. GE is such a large and complex firm that it is difficult even for analysts to be familiar with the totality of its operations, particularly since it had not disclosed much detailed segment information in the past. Also, it was widely known to practice earnings management (see Theory in Practice 11.2). Given numerous financial reporting failures, such as Enron and WorldCom, investors were unable to be sure that GE was not using similar tactics.

Reasons why increased disclosure exerts upwards influence on share price: •

Reduced estimation risk, as investors respond to the firm’s greater transparency. Even if the increased disclosures are bad news, the release of this information will help to counteract any direct effects of the information on share price.

•

Signal. Increased disclosure can be interpreted as a signal, since, according to disclosure principle theory, a company would be less likely to disclose more if the increased disclosure was of bad news.

•

Greater liquidity. To the extent that increased disclosure reduces information asymmetry, the demand for the firm’s shares 517 .

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increases, which increases the liquidity of trading in the firm’s shares This increased liquidity attracts large investors. The increased demand increases share price (Diamond and Verrecchia (1991). b.

Increased segment disclosures will help to reduce investor concerns.

Since the complexity of GE’s operations, and low transparency of reporting, were longstanding investor worries, any increase in transparency, such as increased segment disclosure, will reduce these concerns. Also, accounting standards require segments to be reported on a basis consistent with the firm’s internal organization. Since this basis is of greatest usefulness to investors, the increase transparency from increased segment disclosure is maximized. However, the effect of these transparency increases is reduced by GE’s failure to report separately the earnings of newly-acquired and previously-acquired subsidiaries. The problem seems to arise because the persistence of earnings is likely to differ between them. New subsidiaries may come from diverse industries, with differing earnings persistence characteristics (for example, earnings from acquisition of a well-established business would have greater persistence than those from acquisition of a business with a new and untested product). Furthermore, the products and services of previously-acquired subsidiaries likely have greater, or at least different, persistence than the average persistence of newly acquired subsidiaries. Consequently, failure to report separately complicates the earnings persistence evaluation of GE’s overall earnings. The market may wish to evaluate the performance of new subsidiaries relative to the amount paid for them. If GE has paid too much, for example, the effect will be to reduce GE’s return on capital. Low returns on capital imply lower future expected earnings. This reduces the persistence of GE’s current earnings.

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GE was known to practice earnings management (see Theory in Practice 11.2 and Problem 11.9). This includes increasing current reported earnings by buying profitable subsidiaries during the year. Earnings management strategies in general were under great suspicion at this time. To the extent that GE’s earnings do not distinguish between newly-acquired and established businesses, GE’s ability to practice earnings management is enhanced. A reasonable conclusion is that GE’s increased segment disclosures will decrease investor transparency concerns, but the decrease is less than it would be if GE had separately reported the operations of newly-acquired and previously-acquired subsidiaries. 20.

Costs of increased regulation: •

Direct costs of preparing the additional information, and costs of the bureaucracy needed to enforce the increased regulation.

•

Reduced opportunity to signal by voluntary information release.

•

Possible release of proprietary information by oil and gas firms.

•

Regulator may go too far and impose requirements for which the social costs are less than the social benefits.

Benefits of increased regulation: •

Reduced estimation risk for investors, leading to reduced fear of lemons and better operation of capital markets for oil and gas companies.

•

Reduced concern about possible manager shirking and covering up by inflating oil and gas reserves.

•

Social benefit due to reduced risk of market failure from adverse selection, since less inside information.

•

Social benefit due to reduced risk of market failure from moral hazard, since more difficult for managers to disguise shirking on their efforts to maintain reserve quantities. 519 .

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Reasons to seek exemption from stricter Canadian regulations: •

Lower costs of preparing the information.

•

Increased concern about legal liability under the Canadian regulations, which require additional disclosures, such as for probable reserves. These would be more subject to error than proved reserves.

•

Company shares may be traded in the United States, in which case reserve recognition accounting information would have to be prepared to meet U. S. reporting requirements. Meeting Canadian reporting requirements in addition imposes additional costs.

•

Investors may be used to the U.S. reserve recognition accounting information and would be unable/unwilling to learn how to interpret the more complex Canadian regulations. This argument would apply especially if investors are not fully rational.

•

Company may have something to hide, and may prefer keeping certain reserves information inside instead of releasing it publicly (adverse selection problem)

•

Manager may have shirked and wishes to disguise this by avoiding disclosure of additional reserves information such as probable reserves (moral hazard problem).

The market will realize that an oil and gas firm has inside information

about the types and amounts of its reserves. Under the disclosure principle, a firm that does not release this information will be assumed by sceptical investors to have very low quality reserves. Releasing additional information required by the Canadian regulations, such as probable reserves, will prevent or reduce this effect. This will exert an upward influence on share price.

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Signalling theory complements this argument. If the firm releases additional reserves information, the market will realize the firm is committed to high quality disclosure. This information should be a credible signal since the market realizes that violation of disclosure regulations can impose high penalties. Also, reserves disclosures must be audited by an independent professional (see Chapter 2, Problem 28), further increasing its credibility.

21.

Policies and procedures under which managers can credibly convey

inside information to the Board: •

Appoint financial experts to the Board and to Board committees such as audit and compensation. The expertise of such directors gives other outside directors some assurance that relevant information is examined and understood by competent persons, who will raise questions with management if the information is of low quality.

•

Set and meet deadlines for submission of information, so that Board members are assured that the information they receive is timely.

•

Institute an incentive compensation plan that aligns manager and shareholder interests. Then, managers are less likely to behave opportunistically by submitting low quality information to the Board.

•

Adopt (conditionally) conservative financial accounting policies. Such policies convey bad news information to the board in a timely fashion, and help to overcome any tendency for managers to omit or delay its release. Good news information is less likely to be held back by management.

•

Manager reputation. Information released by a manager that has developed a reputation for high quality financial reporting is more likely to be accepted as credible by sceptical directors than information from a manager without such a reputation. 521 .

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Reasons why public financial statements may be more credible to such

directors than information supplied by management

•

An audit increases the credibility of financial statements.

•

Securities commissions may examine and enforce disclosure rules.

•

Legal liability for misleading disclosures may deter manager from reporting low quality or misleading information in the financial statements.

•

Analysts and the business media will subject the financial statements to close scrutiny.

Outside directors are likely to be more objective and independent of management than inside directors. As information quality available to Board members improves, outside directors can do a better job of advising and monitoring management. Thus, the benefits of outside directors to the firm increases. Assuming that Board structure responds efficiently to such changes, it becomes more cost-effective to bring more outsiders onto the Board.

22.

According to contract theory, bondholders are concerned that

management may reduce their security by, for example, diluting their interests by new bond issues and declaring excessive dividends. Such tactics benefit shareholders at the expense of bondholders. Increased alignment of manager/shareholder interests increases these concerns.

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The Yankee market requires higher disclosure and corporate governance

standards than other U.S. bond markets, since firms issuing bonds on this market are subject to Sarbanes-Oxley. Bond investors will be aware of these higher standards. This reduces somewhat their increased concerns described in a, so that they would accept lower interest rates and/or less stringent debt covenants than they would otherwise.

Foreign firms that have shares listed in the United States will already have to meet the Sarbanes-Oxley requirements. The additional costs to such firms resulting from a new Yankee bond issue will thus be small. These lower costs, together with the benefits of higher disclosure and corporate governance standards on the Yankee market described in the previous point, combine to make this market the lowest cost choice for already-listed foreign firms.

Adoption of IFRS in place of a firm’s previous local GAAP typically results in higher quality financial reporting, or at least accounting standards that are closer to U.S. GAAP. This further reduces the costs of meeting Sarbanes-Oxley requirements, which include disclosure of material correcting adjustments and off-balance sheet activities. c.

According to the Diamond and Verrecchia theory, voluntary disclosure

reduces information asymmetry and estimation risk, thereby facilitating trading, which increases market liquidity. Since the Yankee market is subject to Sarbanes-Oxley and resulting improved disclosure, and listing bond issues on this market is voluntary, liquidity increases for firms that list on this market. Increased liquidity attracts large investors, who are then more willing to buy large bond issues. Large firms, including large foreign firms, respond to this increased liquidity with large bond issues.

Additional Problem 523 .

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In October, 1999, DaimlerChrysler AG started to give more information to

analysts, including production forecasts and earnings outlooks. This increased transparency followed a sharp drop in the firm’s share price following its second quarter, 1999, earnings report, which revealed flat earnings compared to the previous year. Apparently, DaimlerChrysler managers felt that much of the share price decline was a result of investors having been “taken by surprise,” rather than of the flat earnings as such. Financial media at the time reported on a recent meeting of DaimlerChrysler managers in Washington, DC. The meeting was “upbeat,” with discussion of plans for several new vehicles and of continued cost cutting progress.

Required a.

Use the disclosure principle to explain why DaimlerChrysler will reveal this

new information. b.

Does the increased disclosure constitute a signal? Explain why or why

not. Suggest ways that DaimlerChrysler management could credibly signal its upbeat information to the market.

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Suggested Solution to Additional Problem 12A-1 a.

The disclosure principle states that if a manager does not release

information that the market knows he/she possesses, the market will fear the worse and bid down the firm’s share price accordingly. To avoid this, the manager will release all but the worst possible information. For the disclosure principle to explain DaimlerChrysler’s release of production and earnings forecasts, the market must know that the firm manager does possess this information. Clearly, this is the case since any well-managed firm will prepare such projections internally. However, there are additional requirements that must hold if the disclosure principle is to explain the information releases: •

It must not be too costly for DaimlerChrysler to release the information. Here, the main cost would be the proprietary cost of revealing production and earnings plans to competitors. However, the firm must feel that the forecasts are sufficiently “upbeat” that the threshold level of disclosure is attained. That is, beneficial effect on share price exceeds the proprietary costs.

•

The information released must be perceived as credible by the market. Here, credibility is attained because the accuracy of the management forecasts will be verifiable by the market when actual production and earnings are known.

•

According to Dye (1985), the effect on share price of the production and earnings forecasts must not be so strong as to swamp the ability of share price to reveal information about manager effort. If so, the reduced compensation contract efficiency (resulting from a share price that is less informative about manager effort) may outweigh any cost of capital benefits to DaimlerChrysler from releasing the information. For example, the “upbeat” forecasts may derive from favourable economic conditions 525 .

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on production, sales, and earnings rather than manager effort. Then, management compensation (if based on share price performance) will increase, even though the increased compensation is not a result of manager effort. To avoid this compensation cost, the firm may not release the information despite the favourable effect it would have on share price. In this case, DaimlerChrysler must feel that the favourable information is the result of manager effort, due to plans for several new vehicles and success at cost cutting. Consequently, the share price benefits seem to outweigh the contracting costs. b.

Yes, it constitutes a signal. To be a signal it must be less costly for a firm

with inside knowledge of good prospects to release an upbeat forecast than for a firm without such good prospects to release an upbeat forecast. This is the case for DaimlerChrysler’s increased disclosure since the market will be able to verify the forecast ex post. The expected costs of failing to meet the forecast are lower for a firm with inside knowledge of good prospects. This is what gives the signal its credibility. Other ways that DaimlerChrysler could credibly signal its upbeat information include: •

Management could increase its holdings of company stock.

•

The firm could raise new financing by means of bonds rather than by issuance of shares.

•

The firm could increase its dividend.

•

The firm could adopt more conservative accounting policies.

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CHAPTER 13 STANDARD SETTING: POLITICAL ISSUES 13.1

Overview

13.2

Two Theories of Regulation 13.2.1 The Public Interest Theory 13.2.2 The Interest Group Theory 13.2.3 Which Theory of Regulation Applies to Standard Setting?

13.3

Conflict and Compromise: An Example of Constituency Conflict

13.4

Distribution of the Benefits of Information: Regulation FD

13.5

Criteria for Standard Setting 13.5.1 Decision Usefulness 13.5.2 Reduction of Information Asymmetry 13.5.3 Economic Consequences of New Standards 13.5.4 Consensus 13.5.5 Summary

13.6

The Regulator’s Information Asymmetry*

13.7

International Integration of Capital Markets 13.7.1 Convergence of Accounting Standards 13.7.2 Effect of Customs and Institutions on Financial Reporting 527 .

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13.7.3 Enforcement of Accounting Standards 13.7.4 Benefits of Adopting High Quality Accounting Standards 13.7.5 The relative Quality of IASB and FASB GAAP 13.7.6 Should Standard Setters Compete? 13.7.7 Should the United States Adopt IASB Standards? 13.7.8 Summary of Accounting for International Capital Markets Integration 13.8

Conclusions and Summing Up

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

To Review Two Theories of Regulation

Section 13.2.2 is oriented to the so-called interest group theory of regulation put forth by Stigler (1971), Posner (1974), Peltzman (1976), and Becker (1983). While this theory is quite old now, I find it is still relevant and helpful in thinking about the process of standard setting. Students readily see the distinction between the two theories based on the discussion in Section 13.2. However, for instructors who have the time and inclination to cover regulation in greater depth, the above articles are still worth reading. If assigning one of them, I recommend Becker (1983). While my conclusions in the chapter is that the interest group theory reasonably describes actual standard-setting processes, the public interest theory should not be discarded since protecting the public interest is, after all, the goal of regulation. 2.

To Examine Constituency Conflict in Action

The material in Section 13.3, on the proposal to limit the SEC’s power to direct accounting standards, provides a vivid example of the power and influence management can bring to bear. Problem 7 of this chapter provides another example, 528 .

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namely the influence of European banks who disliked the prospect of fair value accounting for financial instruments. Similar conflict with respect to other standards can easily be found. See, for example, Problem 4 re the furore over the FASB’s standard 123R requiring expensing of employee stock options, Problems 12 and 13 re Regulation FD, and Problem 15 re Sarbanes-Oxley.. 3.

To Lay Down Criteria for a Successful Standard

Here, I engage the class in a discussion of the criteria for standard-setting suggested in Section 13.5, arguing that theoretical correctness is not sufficient for successful standard. I then return to the fundamental problem of financial accounting theory introduced in Section 1.10, pointing out that the constituency conflict that characterizes standardsetting illustrates how difficult it is to resolve the problem. Hopefully, however, the book helps the students to see the nature and significance of the problem more clearly. 4.

To Introduce Information Asymmetry Between Firm Manager and Regulator

This is an optional section. While it gives an intuitive discussion of issues and some of the models in this area, it also contains some quite technical material. Nevertheless, since the focus of this book is on information asymmetry, some coverage is appropriate. While to date there is relatively little accounting research on regulation under information asymmetry, this is an area that would benefit from research attention. The adaptation of a model from Laffont and Tirole (1993) is intended to suggest a framework within which to think about the effects of information asymmetry between regulator and manager in an accounting context. The most interesting aspect of the model of Dessein (2002) is the creation of an intermediate body (the standard setter) between the regulator (the securities commission) and the manager, which is of obvious familiarity to accountants.

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To Introduce Benefits and Challenges of International Convergence of

Accounting Standards International convergence of accounting standards is an important topic in financial reporting these days, and is receiving much research attention. Since adoption of IASB standards is at least in part a political decision, and is affected by the social, legal, and political institutions in the countries involved, any discussion of political aspects of standard setting must now include international standards convergence. Since current accounting students will be operating increasingly in an international reporting environment, I suggest concentration on the following points: •

Benefits of international standards convergence. Claimed benefits include lower financial statement preparation costs, lower network externalities, lower costs of capital, and increased foreign and domestic investment. By and large, current research tends to support these claims, although it seems that strong institutions and enforcement are also necessary if these benefits are to be realized.

•

It is unclear whether or not IASB and FASB standards are of equal quality. The results of Barth, Landsman, Lang, & Williams (2006) and Leuz (2003) provide conflicting results, for example. However, quality differences will decline as convergence progresses. A good question for discussion is whether this convergence will continue, due to current differences in fair value accounting (e.g., IFRS 9 re business model, and accounting for loan loss provisioning).

•

Differences in social, legal, and political institutions across countries create different contracting and investing environments, which show up as lower reporting quality than under United States standards, but which actually represent rational responses to these institutional differences. This is the message of the Ball, Kothari, & Robin (2000); Ball, Robin & Wu (2003), and Bushman & Piotroski (2006) papers. The important point is that adoption of IASB standards by countries does not necessarily mean uniform financial statement quality across these countries. Rather, investors should interpret foreign financial

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statements taking into account the specific institutional environment of each country. •

Since the U.S. now accepts financial statements of foreign countries with shares traded in the U.S. without reconciliation of those statements to U.S. GAAP, this seems to imply an acceptance of IASB standards as of equal quality to FASB standards, even though the 2 sets of standards are not completely converged. However, it now seems unlikely that a “big bang” adoption of IASB standards by the U.S. is likely (Section 13.7.7).

•

As an alternative to IASB adoption, should the SEC accept reporting under IASB or FASB standards by all companies within its jurisdiction (i.e., including domestic U.S. companies)? This possibility is of considerable import to Canadian companies, among others. If adopted, it would lead to a measure of competition between standard setters, creating interesting possibilities of a race to the bottom or to the top. Problem 8 of this chapter complements the text discussion in this regard.

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

Under the public interest theory, the regulatory body (e.g., the standard

setter) attempts to produce an amount of regulation that maximizes social welfare, by trading off social benefits and social costs of information production. Standards for which the social benefits exceed the social costs are socially desired. Implementation of all such standards by the regulatory body produces the socially optimal amount of regulation. Under the interest group theory, the regulatory body is assumed to maximize its own interests, not necessarily those of the public. To do this, it supplies regulation to those constituencies that are most effective in lobbying for it. b.

Because of the difficulties of determining the socially optimal amount of

regulation, the regulatory body under the public interest theory may produce more or less than this amount. Under the interest group theory, to maximize its own interests, the regulatory body supplies regulation to the constituency that is most effective in lobbying for the accounting standards it desires. In deciding on how much to spend, lobbying groups take the expenditures of competing lobby groups into account. Depending on the results of this lobbying, more or less information than socially optimal will be produced. 2.

Aspects of the structure of standard setting that facilitate conflict

resolution in the process of setting new standards include: •

Representation of diverse constituencies on the standard setting body.

•

Standard setting bodies are structured so as to be independent of conflicting interests. The IASB and FASB are distinct from professional accounting bodies due to their foundation-based structures. In Canada, while not distinct from the CICA, the AcSB 532 .

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publishes standards “on its own authority.” Most of these standards are from the IASB. •

Contact with constituencies, through due process. This includes broad consultation, discussion papers, exposure drafts, public hearings, issuance of bases for conclusions, and representation of different constituencies on the standard setting body itself.

•

Supermajority voting (See Section 1.12.5). This makes it less likely to result in standards that are opposed by a substantial minority, and helps to encourage a spirit of compromise.

•

Post-implementation review. This is to review the outcomes of any arguments or problems identified during process of developing a new standard and consider any costs or unanticipated problems that may have arisen since the standard was issued.

The reason for supermajority voting, presumably, is to foster a spirit of

compromise and to reduce concerns by any one constituency that others, perhaps constituencies with more spending power, are “ganging up” on them. As a result, constituencies affected by a new standard are more likely to support it than they would be under simple majority voting.

Benefits of adopting IASB standards: •

Better working domestic capital markets, leading to lower firms’ cost of capital as investors perceive lower estimation risk and greater comparability, thereby increasing their demand for shares of the country’s firms. Lower cost of capital leads to increased investment by domestic firms.

•

Companies can access larger and more liquid capital markets to the extent that their financial statements are accepted in other countries.

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Adoption of IASB standards increases the likelihood of acceptance. This can lead to increased foreign investment by domestic companies. •

Increased investor confidence leads to increased supply of investment capital to the economy, both from domestic and foreign investors. This increases capital market liquidity in the domestic adopting country.

•

Lower financial statement preparation costs, since there are then fewer jurisdictions whose reporting requirements must be satisfied.

•

Lower network externalities. To the extent that other countries use IASB standards, it will be easier and less costly for internationally diversified investors to analyze financial statements.

Costs of adopting IASB standards: •

Financial reporting is affected by local customs, laws, and other institutional characteristics. Problems arising from adverse selection and moral hazard are internalized to the extent that interest groups, such as labour, banks, are represented within, rather than outside, firms’ corporate governance. These factors can result in differences in the application across countries of the same set of accounting standards. Investors need to be aware of these differences if they are to properly interpret and compare financial statements from companies in different countries.

•

Increased constituency conflict in the design and implementation of new accounting standards, arising from additional constituencies, customs and institutions affected by the standards. This can lead to compromises which may reduce standards quality, or lead to an increased number of options allowed by standards.

•

Enforcement of accounting standards may differ across countries, since there is no single body, like the SEC in the United States, to apply uniform interpretation and enforcement of IASB standards. Enforcement is up to the countries involved, although IOSCO provides a forum for cooperation. 534 .

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Increased pressure on auditors from influential controlling interests in firms to bend the standards for their benefit. This strains the auditor’s ethical responsibilities and can lead to increased possibility of legal liability.

•

To the extent that IFRS standards encourage small investors, the resulting minority interests may suffer at the hands of large controlling interests that may exploit their control to enjoy excess compensation, perquisites, and related party transactions. The concern of small investors about such exploitation reduces investment in the domestic economy.

Advantages of ESOs as a compensation device, in theory: •

Alignment with shareholder interests. Since the value of ESOs depends on share price, manager effort to increase share value is encouraged.

•

Low downside risk. ESOs are an efficient way to attain a manager’s reservation utility since the lowest they can be worth is zero but they have considerable upside potential.

•

Longer-run decision horizon. Given securities market efficiency, share price will respond negatively to short-run manager actions to increase earnings, such as reduction of R&D and deferral of maintenance. This encourages a longer-run manager decision horizon.

•

No cash outlay. Rapidly growing firms are often short of cash. They value the ability to compensate employees, including managers, without a cash outlay. Indeed, some cash is received instead.

•

No effect on net income. During the years leading up to the 2004 debate, no expense needed to be recorded for ESOs. This reduced firms’ concerns about debt covenant violation and, to the extent

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securities markets are not fully efficient, lowered their costs of capital. b.

Some negative effects of ESOs in practice: •

ESOs seem to have had the effect of shortening rather than lengthening some managers’ decision horizons. This led to opportunistic behaviour to increase share price in the short run, such as pump and dump, and announcement of bad news, but not good news, shortly before scheduled ESO award dates

•

Late timing, another type of opportunistic manager behaviour, leading to overstatement of reported earnings and possible excess manager compensation since ESOs were, in effect, issued in the money..

•

Pressure to meet earnings forecasts. Since the value of an ESO depends on share price, and since share price suffers severely if investors’ earnings expectations are not met, some managers resorted to opportunistic tactics to inflate reported earnings.

•

Excessive risk taking. Due to high upside rewards and low downside risk, holders of ESOs had everything to gain and little to lose. This encourages management strategies that, even from a diversified shareholder perspective, may be too risky. Examples include excessive leverage of financial institutions leading up to the 2007-2008 market meltdowns, and disguising of leverage through use of off-balance sheet entities.

Yes, ESOs are an expense. By issuing shares through ESOs the firm

foregoes the ability to issue these shares to investors at market price. This creates an opportunity cost that dilutes the value of the shares of the existing shareholders. Recording an expense equal to the fair value of ESOs measures this opportunity cost. 536 .

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The actions of the opponents of ESO expensing are most consistent with

the interest group theory of regulation. They are actively lobbying the legislature to defeat the FASB’s proposed standard. The FASB’s actions can be interpreted as consistent with either theory. The FASB may believe that expensing ESOs will help to control some of the negative effects of ESOs outlined in b, and generate reported net income that better measures the firm’s performance. Then, capital markets in the United States will work better. This suggests the public interest theory. However, The FASB’s actions can also be interpreted as most consistent with the interest group theory. The FASB realizes that failure to push through the expensing standard will negatively affect its status as a standard setting body. Consequently, by pushing through ESO expensing, it is also seeking support (i.e., lobbying) in the legislature and from prominent officials. e.

Decision usefulness. The decision usefulness of the proposed standard

depends on its trade-off between relevance and reliability. Relevance will increase since lower reported net income resulting from ESO expensing anticipates the lower per share dividends that will result from the dilution created by ESOs. However, one of the concerns raised by FASB opponents is lack of reliability. A main reason for reduced reliability is that option pricing formulae, such as Black/ Scholes, do not apply directly to ESOs. For example, the Black/Scholes formula does not allow for early exercise. This creates a need to estimate the exercise behaviour of ESO holders. Such estimates are low in reliability. Even if accurate estimates are available, the Black/Scholes formula may, under some conditions, overstate ESO cost. The effect of the proposed standard on decision usefulness also depends on the extent of securities market efficiency. The fair value of ESO expense was already shown in the financial statement notes under SFAS 123. If the market is efficient, recording an expense in the financial statements proper would add nothing to what the market already knows.

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Reduction of information asymmetry. Again, this depends on the extent of securities market efficiency. If markets are fully efficient, there is no reduction since the market already had the expense information under SFAS 123. However, reporting expense in the income statement may assist investors subject to behavioural biases to realize ESO cost, thereby reducing information asymmetry between such investors and management. Economic consequences. According to the FASB’s opponents, the economic consequences will be severe. Indeed, this is the main source of their concerns. However, since the interest group theory applies to their actions, one can question if these consequences will be as severe as claimed. Many of their arguments seem to assume securities market inefficiency. Other economic consequences include an increased probability of violation of debt covenants due to lower reported net income. Also, many companies seem to be signalling inside information and their commitment to full disclosure by voluntarily adopting expensing. Their ability to reveal inside information in this manner would be eliminated if expensing becomes mandatory. Presumably, the FASB is aware of these consequences but feels that they are outweighed by the claimed benefits of expensing. Consensus. Clearly, there did not exist a consensus on the proposed standard, despite the due process of the FASB. The success or failure of the standard, and thus the FASB’s reputation, depended on the outcome of the parties’ various lobbying efforts. 5.

This sequence of events is most consistent with the interest group theory.

Under the interest group theory, constituencies affected by a proposed accounting standard may lobby the legislature so as to attempt to influence the standard in a manner favourable to their own interests. Ultimately, it is the legislature (here, the U.S. Congress) that has the power to decide whether the proposed regulation should proceed and, if so, its contents. In this case, a particular constituency, namely, bank executives, which fears adverse economic consequences from fair value accounting, is lobbying to “kill” 538 .

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the FASB and turn standard setting over to a possibly more political body, the SEC. Presumably, the bank manager constituency feels that the SEC will be more amenable to its wishes and concerns. b.

The bankers’ concerns have some merit to the extent that liquidity pricing

should it develop, produces fair values less than value-in-use. If so, banks’ required legal capital ratios are reduced unduly, possibly leading to insolvency, government bailouts or takeover, and instability of the economy’s financial system. The possibility of liquidity pricing is supported in practice (see Section 1.3), although, as the events leading up to the 2007-2008 security market meltdowns suggest, liquidity pricing was precipitated by the actions of the financial institutions, not the FASB. However, standard setters did relax some fair value rules during the crisis (Section 7.5.1), such as allowing firms to use their own cash flow expectations when markets were inactive, and increased use of historical cost if declines in value were felt to be temporary. Subsequently, the IASB has moved to back off some of the fair value accounting rules for financial instruments, such as IFRS 9 and IFRS 7(Section 7.5.2), which allow amortized cost accounting (i.e., value-in-use) for debt assets if the objective of the firm’s business model is to hold them to collect interest and principal; and require increased disclosure. Perhaps the FASB will adopt similar standards. Standards such as these should reduce some of the bankers’ concerns about fair value accounting. However, value-in-use may reduce reliability, since value-in-use estimates are subject to possible manager bias. c.

Costs of moving standard setting to the SEC: •

Given the complexity of determining the socially “right” amount of regulation, there is no guarantee that the SEC will be more effective than the FASB in this regard. That is, the SEC may be just as prone to over-regulation (the concern of the bankers) or underregulation as the FASB.

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As a bureaucracy in its own right, the costs of setting and administering accounting standards by the SEC may be greater than under the FASB.

•

The structure of the FASB is designed to encourage the pursuit of compromise and consultation in standard setting. This is due to representation of diverse interests, to discussion papers, exposure drafts, public hearings, and post-implementation reviews. As a body that may be subject to greater political pressure than the FASB (the bankers seem to think so), standards set by the SEC may be more one-sided, tending to favour a constituency with great political power and lobbying resources (i.e., business management). The wrong amount of standard setting can entail substantial costs to society.

•

To the extent that investors accept the due process of the FASB, moving standard setting to another body may reduce public confidence in the proper operation of capital markets, thereby increasing estimation risk and firms’ cost of capital.

Benefits of moving standard setting to the SEC: •

Being closer to the political process, the SEC may have a better feel for what the public interest is, thereby favouring the public interest theory of regulation.

Under the public interest theory of regulation, the standard setter attempts to maximize social welfare. The standard setter may believe that adopting IASB standards will improve the operation of domestic capital markets, reducing firms’ costs of capital and attract increased foreign investment. The financial statement preparation costs of domestic firms whose shares are traded in more than one jurisdiction will be lowered if a single set of financial statements satisfies the accounting requirements of all jurisdictions. 540 .

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The ability of domestic firms to raise capital will be improved if they can tap the capital markets of other countries. Ability to raise capital will be improved to the extent that foreign investors are already familiar with IASB standards It is difficult to explain adoption of IASB standards from the interest group theory perspective, since the domestic standard setter is giving up its authority to an international body. A possible explanation is that the standard setter may feel that it will have influential inputs into IASB deliberations, through increased representation on the IASB Board and membership on numerous committees. If so, it may feel that its power is enhanced because the world stage is much larger than the stage in any one country. Also, the standard setter may give increased attention to accounting standards for non-public companies and non-profit institutions, which may not be subject to IASB standards. It may feel that increased influence in setting standards in these areas will counteract any reduction in its influence over public company standards. 7.

Suggested reasons why banks and insurance companies are concerned

about volatility: •

They may feel that to the extent that financial instruments are to be held to maturity, fair value is not relevant. Note: However, IAS 39, as is currently the case under ASC 320-10 of the FASB, allowed financial instruments that are to be held to maturity to be valued on a cost basis, subject to an impairment test.

•

Income statement volatility may be interpreted by investors as indicating instability of the financial institution, thereby increasing cost of capital.

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Increased probability of violating regulatory capital constraints. To the extent that financial instruments are fair valued, shareholders’ equity is more volatile if changes in fair values are not fully hedged or otherwise offset.

•

To lessen interest rate risk, thereby lowering earnings volatility, financial institutions may shorten the terms of their loans and fixed-term financial instruments if these are fair valued. Reduced availability of long-term capital could have adverse effects on economic activity.

•

To the extent that market values are not readily available, other valuation approaches, such as models or value-in-use, may be unreliable. This would affect investors’ estimation risk, increasing cost of capital.

Costs of the SEC’s allowing both FASB and IASB standards: •

Possible race to the bottom, whereby each standard setting body lowers its standards to attract firms to its version of GAAP. This would lower the amount of useful information to investors and negatively affect the working of capital markets.

•

Possible race to the top, as both standard setters increase financial reporting quality so as to attract firms that wish to obtain benefits such as lower cost of capital by signalling a commitment to high reporting quality. If this goes too far, it would result in more information production than is socially desirable.

•

Increased network externalities. Investors would face costs of having to learn to interpret 2 sets of standards.

Benefits of the SEC’s allowing both FASB and IASB standards:

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Easier access to U.S. capital markets by foreign firms. This would lower their costs of capital due to the liquidity of the U.S. markets.

•

Ability to signal. Firms could signal their commitment to full disclosure and transparency choosing the highest quality set of standards.

•

Competition may reduce the tendency of standard setters to over- regulate by mandating more standards than socially desirable, particularly if the interest group theory of regulation applies.

The carveouts will likely reduce the probability of the SEC accepting IASB

standards. To the extent that a major constituency such as the EU rejects, modifies, or delays acceptance of, IASB standards, the confidence of the SEC in the IASB standard setting process is reduced. Also, to the extent the IASB modifies its standards to secure EU acceptance, this may move IASB standards farther from FASB standards, making SEC acceptance of and convergence with IASB more difficult. 8.

With a race to the top, each standard setting body competes by raising

the quality of its accounting standards in the expectation that firms will choose high quality standards over low quality standards. b.

The reasons for a race to the top derive from incentives that firms have to

issue high quality information: •

High quality information reduces investor estimation risk, thereby lowering cost of capital.

•

Managers may wish to increase their market value and reservation utility by earning a reputation for high quality reporting.

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Firms that wish to signal their commitment to high quality reporting will choose the higher quality set of accounting standards. Standard setters will respond to this increased demand by raising standards’ quality.

•

To the extent that standard setting bodies accept the public interest theory of regulation, they will feel that high quality accounting standards are in the public interest.

The main difficulty is reduced comparability of foreign and U.S. firm

financial statements. That is, if the SEC accepts IASB standards without reconciliation, investors’ network externalities increase. Without reconciliation, and in the absence of full standards convergence, investors must become aware of differences between two sets of standards. Even with convergence, investors must also be aware that IASB standards may be applied differently by firms in different countries, due to differences in customs, legal and other institutions, social tensions, and government influence. Furthermore, some firms may adopt IASB standards with the intention of using them as a “label,” that is, to gain the benefits of investor perception of IASB standards quality and comparability, but intending to use the flexibility of GAAP to make few changes to the accounting policies they are already using. 9.

The first item represents the increase during the quarter in the fair value of

TD’s available-for-sale securities. These securities are valued at fair value for balance sheet purposes, and changes in fair value are unrealized, hence included in other comprehensive income. It seems that TD hedges at least some of its risk of changes in fair value of its existing available-for-sale securities using cash flow hedges. Since cash flow hedges hedge anticipated transactions, TD must plan on selling some of its available-for-sale securities in future periods and wishes to ensure that cash equal to their fair value at time of hedge designation is received. The $87 is then a net amount, since the total change in fair value of its available-for-sale securities is reduced by the (opposite) change in fair value of related hedging instruments.

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The second item represents the gains realized by TD on sales of its availablefor-sale securities during the quarter. These gains are transferred out of other comprehensive income to net income. The third item represents the unrealized gains from changes in fair value of derivatives designated as cash flow hedges. Unrealized gains and losses on such instruments are included in other comprehensive income until the hedged transactions take place. These hedged transactions must be other than future sales of available-for-sale financial instruments, otherwise they would be included in the first item. b.

The purpose of other comprehensive income is to reduce the volatility of

reported net income that would result from fair valuing financial assets without also fair valuing all financial liabilities. The standard represents a political compromise, since management objects to net income volatility, particularly if that volatility exceeds the real firm volatility that management has chosen through its natural and derivative hedging activities. To secure management’s acceptance of fair valuing financial assets on the balance sheet, unrealized fair value gains and losses are excluded from net income until realization. Note: Instructors may wish to discuss the use of the fair value option as another way to reduce net income volatility. c.

An alternative treatment is to include other comprehensive income items

on the income statement, below net income, to arrive at comprehensive income in a single statement. Alternatively, another alternative would be to report a separate other comprehensive income statement immediately following the income statement. Note: These are now the two acceptable alternatives under IASB and FASB standards, see Section 1.10 By using the then-available option of reporting other comprehensive income as part of a statement of equity, TD management must have felt that unrealized gains and losses included in other comprehensive income are not informative 545 .

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about its effort in managing the firm, and thus wishes to separate them as much as possible from net income. Note: In parts d and e, either measure of performance can be chosen for the answer, providing it is adequately supported. The following points are suggestive of arguments that can be made. d.

The earnings measure that generates the highest main diagonal

probabilities of the information system is the most useful for an investment decision. Arguments in favour of net income as most useful are: •

Unrealized gains and losses on marketable securities may never be realized. That is, they are of low persistence, and introduce considerable volatility into comprehensive income. Consequently, they add mainly noise, which reduces the main diagonal probabilities of an information system based on other comprehensive income. This reduces informativeness about the future performance of TD. Basing investment decisions on net income removes this source of low persistence, volatility, and noise from the information system.

•

To the extent that properly working market values are not available for the securities, the firm must use Levels 2 or 3 of the fair value hierarchy. Then, unrealized gains and losses may be low in reliability. Including such items in net income also lowers the main diagonal probabilities. Again, this supports basing investment decisions on net income.

Arguments in favour of other comprehensive income as most useful include: •

Current market value is the best predictor of future value of marketable securities, since market value is equally likely to move up or down when markets work well. Consequently, unrealized gains and losses add relevance to the information system. This supports basing investment decisions on comprehensive income.

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Most marketable securities have a market value. Consequently, the reliability of fair values and resulting unrealized gains and losses should be reasonably high.

Arguments in favour of net income as most useful for purposes of

determining cash bonuses include: •

Risk. Since fair values of marketable securities are volatile, basing cash bonuses on comprehensive income decreases precision, thereby increasing the risk averse manager’s compensation risk. This lowers expected utility of compensation, requiring the firm to raise expected compensation if the manager is to attain reservation utility. As a result, the compensation contract is less efficient and compensation expense is higher.

•

Informativeness about effort. To the extent changes in market values of marketable securities are due to economy-wide factors, they may be less informative about manager effort. if so, basing bonus on other comprehensive income reduces effort informativeness. This negatively affects contract efficiency.

•

Inclusion of unrealized gains and losses on available-for-sale financial instruments for bonus purposes could have economic consequences, because of management’s reaction to the resulting earnings volatility. For example, management might reduce TD’s holdings of longer-term and risky financial instruments, or may engage in excessive, costly, hedging, to control this volatility.

Arguments in favour of comprehensive income as most useful for purposes of determining cash bonuses include: •

While the manager cannot control the market value of marketable securities, he/she can control the amounts and timing of investments in these financial instruments, including any related hedging. Consequently, unrealized gains and losses on marketable securities are informative 547 .

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about manager effort to some extent, and so should be included in income for bonus purposes. 10.

According to the public interest theory of regulation, OSFI would approve

the direct charge to retained earnings if it was concerned about Scotiabank’s loan quality. OSFI knows that the failure of a major bank, or even public concern about a bank’s financial condition, would cause significant economic and social harm, and wishes to minimize the probability of this happening. Consequently, it encouraged Scotiabank to provide a “generous safety cushion” for loan losses. Obviously, Scotiabank was concerned about reporting a lower net income for 1999 than for the two previous years, and may not have planned to provide as large an amount for loan losses as OSFI felt was needed. To encourage Scotiabank to provide a larger amount, OSFI granted the special permission. b.

Under the interest group theory of regulation, OSFI wants to maximize its

power and influence, and will thus respond to the most effective lobbying constituency. Presumably, this is the banking industry, and Scotiabank in particular. By, in effect, setting accounting standards for the banking industry, OSFI is increasing its sphere of influence relative to competing constituencies (CICA and OSC), increasing its influence over the banks, and increasing its visibility in the eyes of investors. c.

Three arguments are possible here. First, the securities market would not

respond, since the direct charge to retained earnings does not affect cash flows, and is fully disclosed. Second, the market might respond negatively. The direct charge in addition to specific loan loss provisions may reveal new information that Scotiabank’s loan quality was less than previously expected. Furthermore, the direct charge may reveal inside information that Scotiabank’s management was concerned that net income would not “stand” the full amount of the needed provision. Indeed, if one deducts the after-tax amount of the direct charge from 1999 reported net income, the result of $1,237 suggests a declining earnings trend over the three years.

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Both of these effects would cause a negative market reaction to Scotiabank’s shares. Third, the market might respond positively. It may feel that Scotiabank is facing up to its loan problems by “clearing the decks.” Management will now take steps to ensure that similar problems do not arise in future, so that loan quality is expected to improve. 11.

The most likely reason is that a firm’s business model is difficult for a manager to change, particularly given a reasonable standard of corporate governance (IFRS 9 expects such changes to be rare). Then, management’s ability to change accounting policies opportunistically/strategically is constrained, thus less of a “shifting sand.” That is, relating the basis of valuation to the firm’s business model reduces the ability of the manager to cover up shirking by opportunistic earnings management as, for example, in gains trading. In addition, the IASB may feel that a value-in-use basis of valuation of financial instruments is of greater decision usefulness to investors than fair value, given the intent to hold the instruments to collect interest and principal. An alternate reason, based on the interest group theory, is that the IASB may feel that unless it backs off somewhat from full fair value accounting, it will lose power and prestige, since governments, who may be influenced by interest groups with high lobbying power, may step in to override fair value standards.

12.

The concern arose because it was felt by critics that there would be more

publicly-available information between earnings announcements, since firms would have to make any announcements available to everyone. Before regulation FD, firms could release information only to analysts, who would often smooth or delay its public release in return for receiving it privately and, presumably, hoping to receive continuing inside information in future.

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However, releasing information publicly between earnings announcements would increase the volatility of firms’ share prices. To reduce this volatility, it was feared that firms would reduce the information they released between-earnings announcements. This would leave a greater proportion of total firm information released when earnings were announced, giving firm insiders more time to exploit their information advantage, leading to higher abnormal share return volatility at earnings announcement time. This concern does not appear to be borne out by subsequent empirical evidence. Francis, Nanda, and Wang (2006) found no increase post FD in abnormal share returns, either between or surrounding earnings announcement dates, implying that Regulation FD had little effect on information coming to the market. b.

Eleswarapu, Thompson, and Venkataraman (2004) found that the

average bid-ask spread of their sample firms fell post-FD, implying less investor concern about adverse selection and resulting estimation risk, supporting the FD goal of a fairer marketplace. However, Sidhu, Smith, Whaley, and Willis (2008) report a contrasting result. They found, after controlling for changes in other factors affecting the bid-ask spread, that the adverse selection component of the spread actually increased. Francis, Nanda, and Wang report lower abnormal share returns around analyst forecast release dates post FD, suggesting a decrease in analyst information advantage. Kross and Suk (2012) also report evidence consistent with a decline in analysts’ information advantage. A reasonable conclusion is that Regulation FD seems to have reduced analyst information advantage, but the extent to which it has increased investor perceptions of a fair marketplace is unclear. 13.

The market failure derives from adverse selection. Investors felt that

managers were engaging in selective disclosure. That is, inside information was released to certain individuals, such as analysts, who had the opportunity to take advantage of it before passing it on to the market. This practice increased estimation risk for ordinary investors, causing them to lower the amount they 550 .

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were willing to pay for all shares and, in extreme cases, leave the market. In effect, the market was not working as well as it should. b.

Market liquidity will be reduced by this practice. Both market depth and the

bid-ask spread will be affected. The depth component of market liquidity will fall as ordinary investors leave the market. The bid-ask spread component will rise as a result of this practice, as investors perceive that inside information is in the hands of a group of analysts and big institutional investors who will, presumably, use it for their own advantage at ordinary investors’ expense. Liquidity is important if markets are to work well because: •

Market liquidity (depth) enables investors to buy and sell large blocks of shares without affecting the market price. If investors cannot do this, their demand for shares will fall, since they will have to pay more to buy and will receive less if they sell. That is, costs of trading increase. This reduces demand for shares and some investors may actually leave the market. The market works less well since lower demand lowers share prices, increasing cost of capital.

•

Higher bid-ask spread decreases market liquidity. The bid-ask spread is increased by investor concern about adverse selection. Concern about adverse selection also lowers investor demand for shares, with effects similar to lack of market depth. That is, the market works less well due to lower share prices and increased cost of capital.

Sources of costs resulting from Regulation FD: •

Potential litigation cost resulting from contravening Regulation FD. Such contravention could be inadvertent, resulting, say, from a casual comment by a firm manager to an institutional investor.

•

Costs of meeting the regulation, such as policies and procedures to communicate information widely, including conference calls and web page design and operation. 551 .

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The cost of a bureaucracy to enforce the regulation.

•

An increase in expected costs of litigation from failure to meet forecasts. If a firm publicly releases a financial forecast that turns out not to be met, it will likely face litigation or, at the least, a substantial drop on its share price. However, if the forecast had been informally released to, say, an analyst, and allowed to filter into the market through that analyst’s forecast and recommendations, the analyst will bear some of the costs of not meeting the forecast.

•

Increase in private information search costs. To the extent that analysts spend more time to develop their own firm-specific information, rather than having it handed to them by the firm, costs of private information search will increase. That is, several analysts may incur costs to discover the same information. This is socially wasteful.

14.

The most likely reason is that Air Canada wanted to avoid a large decline

in its stock price if its quarterly report revealed unexpected bad news. By releasing the information early through analysts that were obviously “friendly,” the company may have felt that by “talking down” the analysts they would diffuse or water down the bad news. This would reduce share price volatility. An alternate reason is that Air Canada’s management may have felt that releasing the information early, even though it was bad news, would enhance its reputation for full information release on the securities and managerial labour markets. This would favourably affect Air Canada’s cost of capital and management’s reservation utility, helping to counteract the effects of lower earnings. b.

One reason why Air Canada’s share price fell is that the market was

reacting to the bad news of lowered earnings forecasts. This information was not previously in the public domain. A second reason is that by revealing inside information to a select group, investors felt that the market for Air Canada shares was not a level playing field. 552 .

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The resulting drop in market depth and increase in bid-ask spread lowered share price. A third reason is that the market as a whole may have dropped on those days, pulling Air Canada’s share price down with it. The problem does not give sufficient information to determine the extent to which this was the case. Finally, the market may have anticipated the fines and legal costs that would result if the disclosure violated Canadian securities legislation. c.

The market does not work as well as it might with selective disclosure.

Selective disclosure increases investors’ concern about adverse selection, increasing their estimation risk, leading to perceptions that the market is not a level playing field. The resulting is a decrease in market liquidity (bid-ask spread), with negative effects on share prices, firms’ costs of capital, and the efficiency of capital allocation in the economy. d.

This trade suggests adverse selection. A possible reason for the huge

block sale is that an insider is taking advantage of inside information about expected future earnings of Air Canada. Alternatively, or in addition, the seller knew of the plan by Air Canada to talk down analysts and anticipated the negative effects of investor reaction on its share price. e.

Air Canada should have been charged regardless. The problem is one of

perception. Investors do not know whether or not the selected analysts used the information for personal gain. But, the possibility existed. Thus investors do not regard the market as a level playing field. This causes harm to the operation of the market. Air Canada’s selective disclosure policy, even if the analysts did not personally take advantage of the information, is the source of this harm.

15.

The socially correct amount of information is the amount that equates the

marginal social costs and marginal social benefits of that information. 553 .

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Costs of Section 404 to shareholders and the economy: •

Out-of-pocket costs to establish, evaluate, and audit the internal control system. These costs will ultimately be borne by shareholders.

•

Manager time and energy devoted to meeting Section 404 requirements, which reduce time available for other manager activities. This threatens the company’s productivity and innovation.

•

Increased risk for senior managers who certify the system as required by Section 404. If some important control has been missed, and an internal control deficiency has become apparent, the managers could suffer loss of reputation, position, and possible prosecution. Given efficient compensation contracting, higher risk requires higher expected compensation to maintain risk-averse managers’ reservation utility. Increased compensation expense is borne by the shareholders.

•

Possible overspending on corporate governance and internal controls. Since managers are responsible for failures in meeting Sarbanes-Oxley Section 404 requirements, but do not personally bear the all of the costs of meeting the requirements, managers will have the firm overspend on protecting themselves from possible failures (moral hazard problem).

•

Possible reduction in manager’s incentives to undertake risky projects. Such projects may have positive expected value a priori, and would benefit diversified shareholders. However, if the project goes wrong, increased scrutiny of the manager’s Section 404 disclosures could damage his/her reputation and compensation, and lead to legal liability.

•

Less good earnings management, since managers may fear that earnings management of any type is in such bad repute that it leads to suspicion, reputation damage and possible liability.

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Costs to the economy as firms, especially foreign firms, withdraw to other capital markets. These costs include reduced underwriter and brokerage fees, fewer head offices, and less liquid capital markets.

•

Increased costs of the bureaucracy needed to monitor and enforce compliance. These costs include costs of the Public Company Accounting Oversight Board (see Section 1.2).

Benefits to shareholders and the economy: •

Fewer financial reporting scandals, reducing damage to the economy and recession caused by investors losing faith in capital markets.

•

Firms, particularly foreign registrants, enjoy lower cost of capital, due to lower estimation risk. This increases share prices and improves productivity.

•

Improved corporate governance, if the firm’s governance was previously below its optimal level. Benefits of improved governance include reduced likelihood of financial reporting failures, more informative earnings reports, increased efficiency of compensation contracts and, more generally, reduced agency costs due to less influence and power of insiders within the firm.

• Less bad earnings management. Despite the difficulties of evaluating the social costs and benefits of information, a reasonable conclusion is that Section 404 pushed information production beyond the social optimum. This is evidenced by the complaints of firms, Treasury Secretary Paulson, and the Committee on Capital Markets Regulation. Withdrawal of foreign firms from U.S. capital markets imposes additional costs. In retrospect, the Relaxation of some Section 404 requirements by the SEC supports this conclusion. b.

Favourable effects on social welfare: 555 .

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• By reducing auditing costs, easier for private companies (defined as companies with revenues less than $1 billion) to raise capital through an IPO. • More IPOs generates increased investment in the economy. • More IPOs and increased investment generate more jobs in the economy. Unfavourable effects on social welfare: • Less motivation to increase internal controls over financial reporting. • Low quality internal controls increase ability of managers to opportunistically manage financial reports so as to increase proceeds of IPO. • Increased investor concern about adverse selection, since managers willing to issue misleading financial reports are attracted to the opportunity. This leads to a less liquid market for the IPO and a lower offering price, which would lower investment and jobs in the economy. • Increased costs for investors to conduct their own investigations into the quality of IPOs. The net effect on social welfare depends on whether the benefits to managers and the economy through increased investment and jobs outweigh the risks of lower quality financial reporting to investors. If investors respond by refusing to buy IPOs of emerging growth companies, or to lower the price they are willing to pay, the net effect for society may be negative. c.

A principles-based approach to regulation of financial accounting and

reporting is feasible providing clear general rules are laid down by the regulator, and accountants and auditors exercise responsible and ethical judgement in applying the general rules. To do this, auditors and accountants must put their longer-run interests (which conform to society’s interests), ahead of the wishes of clients who may wish to behave opportunistically. 556 .

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However, principles-based accounting standards come under considerable pressure due to concerns of auditors and accountants about legal liability, particularly in a litigious society such as the United States. It is easier to defend a lawsuit if it can be shown that there are clear rules which have been followed. It seems that whether or not principles-based standards can be maintained without regressing to rules-based is an open question. 16.

Benefits of a set of high quality global accounting standards: •

Lower financial statement preparation costs for multinational corporations, since a common set of statements suffices for all countries in which the firm’s shares are traded.

•

Lower costs from reduction of multiple exchange listings for multinational corporations.

•

Higher earnings quality in countries for which previous standards were of lower quality than IASB standards, leading to increased investor confidence in a fair marketplace, reduced estimation risk, and greater market liquidity, resulting in lower costs of capital for domestic firms and greater foreign investment.

•

Lower costs of capital and greater foreign investment lead, in turn, to increased capital allocation efficiency and economic development.

The role of a country’s auditing profession in implementing a set of high

quality global accounting standards includes helping to ensure that the standards are enforced. Even the highest quality standards will not produce benefits if investors are not confident that the standards are actually being enforced. This is particularly the case if the country’s regulatory and legal system is weak, since the international securities commission (IOSCO) likely has little or no jurisdiction in the country. The auditing profession, by, for example, ensuring full disclosure, helps to protect minority investors from exploitation by powerful majority interests. This 557 .

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protection contributes to increased domestic investment and more efficient contracting. c.

High quality global standards and a strong audit profession need not lead

to a uniform high quality of financial reporting across countries. Reasons include: •

Different legal and institutional environments (e.g., common law v. code law) lead to different agency costs across countries. For example, there may be more insiders in code law countries.

•

More insiders means less need for prompt disclosure of gains and losses, creating different recognition lags across countries.

•

More insiders means less need for conservative accounting to control managers’ temptations to overstate profits. These temptations are internalized with more insiders

•

Greater government influence in different countries leads to a greater tendency to accelerate recording of gains and to smooth losses, so as to preclude possible government takeover.

These differences do not necessarily indicate more opportunistic reporting in some countries than others. Rather, they indicate rational responses to differences in the reporting environment. Nevertheless, international investors should be aware of potential differences in reporting quality when using financial statements of foreign countries. 17.

Listing on a U.S. stock exchange is a credible signal of commitment to

high quality reporting and corporate governance because the expected costs to a firm that does not intend to implement high quality reporting and governance are higher than costs for a firm that does so intend. The stock market will be aware of these cost differences and will expect that only firms with high reporting and governance intentions will register. This is what gives the listing decision its credibility.

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Reasons why companies located in countries with weak institutional

structures supporting their capital markets are likely to face high costs: •

The home country has not adopted IASB standards. Since evidence suggests that adoption of IASB standards results in higher quality reporting (Section 13.7.4), firms in countries not using these standards will need to improve their reporting systems to a level required by IASB standards. These improvements will incur costs.

•

Laws enforcing auditor liability vary across countries. Companies from countries with relatively low auditor liability may receive low quality audits (Section 13.7.3). Such companies will face higher audit costs if they list in the U.S. since they will need to protect themselves from possible violation of U.S. reporting requirements (e.g., Sarbanes-Oxley).

•

Countries vary in the protection offered to minority shareholders. Companies from countries with relatively low protection and high ownership concentration may wish to signal to small investors, including those in the United States, a commitment to protect their interests. This will require higher audit costs (Section 13.7.3) and costs to improve corporate governance.

•

Government interference in financial reporting varies across countries. Companies from countries with relatively high government interference may bear costs of government and minority displeasure in their home country (Section 13.7.2) if higher IASB standards give them less flexibility to manage earnings so as to avoid these costs.

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High

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High Pressure

Low Pressure

125, 110

- 100, 100

0, 10

0, 0

Pressure

Low Pressure

18.

A Non-Cooperative Regulation Game between Investors and Management

Management

Investors

The Nash equilibrium is investors play high pressure, managers play low. 560 .

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The first number in each box is the investors’ cost, the second is the managers’ cost. Each player has the option of organizing and spending the amount specified to influence the regulator (high pressure) or not organizing and giving up (low pressure). In the upper left box, both parties exert high pressure. Investors organize (cost of 25) and spend the maximum on lobbying to thwart management (100) for a total of 125. To thwart investors, management must spend at least the amount spent by investors (125), which exceeds their limit of 110. However, the upper left box will not happen. Both parties prefer to move to the upper right box. If management gives up, investors need only organize, cost of 25, to generate gains of 125 from the standard, for a net gain of 100. Since management gives up in this box, it does not organize, and suffers a loss of 100 when the new standard is implemented. The lower left box is also ruled out. Investors would prefer this box (cost of zero) to upper left. Management also prefers this box. While it must organize, cost of 10, to oppose the standard, it needs to spend nothing on lobbying since investors have given up. However, management would then move to the lower right box since, in the absence of investor activity it does not need to organize to oppose the status quo. But then, investors would move to upper right box to realize the net gains from regulation (-125). Then, management incurs the cost of the regulation (100), but this is less than the cost of playing strong of 110. Neither party has an incentive to depart from the upper right box. Thus, given the cost assumptions, regulation is the predicted outcome of the game. c.

If the benefit to investors is 90, while holding organizing cost at 25, the

maximum amount investors would be willing to spend to lobby for regulation falls from 100 to 65. However, management is still willing to spend 100 on lobbying to avoid regulation. Then, investors realize that if they organize management will outspend them, so they will give up and spend zero. Management only has to spend 10 to organize, and need not spend anything on lobbying. Their low organization cost is a credible threat that if investors organize they will be outspent. Thus the status quo of no regulation prevails. The lower right box is the Nash equilibrium.

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19.

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Inclusion of unrealized gains and losses in other comprehensive is most

consistent with the interest group theory. Valuation of assets and liabilities at fair value, which is the goal of standard setters, requires the recording of unrealized gains and losses. Management objects to recording of unrealized items in net income on grounds that they are volatile, uncontrollable, and uninformative about their effort. Consequently, to secure agreement from the management constituency for fair value accounting, the standard setters compromised by creating a category of other comprehensive income outside of net income. b.

Given management’s dislike of disclosure of unrealized gains and losses,

the most likely reason is to distance these items as far as possible from net income. Management may have believed that they are less noticeable in a statement of changes in shareholders’ equity. c.

Inclusion of other comprehensive income in a separate statement of

changes in shareholders’ equity is not consistent with managers’ acceptance of securities market efficiency, since under efficiency the market will evaluate information in the financial statements regardless of its location.

20.

Finite insurance seems reasonably effective as a smoothing device. Firms

that anticipate a loss, or that are particularly anxious to avoid reporting the loss, may take out such coverage to, in effect, hedge the possibility of the loss. If there is no loss, premiums are returned, less a fee to the insurance company for this service. If there is a loss, its amount is smoothed over the policy term. There appears to be no reason under GAAP why a firm cannot do this. A possible weakness, however, is that there should be full disclosure of the transaction and any losses incurred. Since there is a possibility of abuse of finite insurance, as in the case of AIG, or if the insurance is taken out retroactively (see b), the firm may get into serious trouble due to loss of investor confidence and/or lawsuits if full disclosure is not made.

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One might ask, why does the firm not simply insure against losses through standard liability and disaster insurance policies? A possible answer is that the firm may feel that the likelihood of a specific loss is low and that it is less costly to self-insure by means of finite insurance. Also, some losses may be uninsurable (e.g., if negligence or fraud) and finite insurance is a way to smooth them out if they occur. Nevertheless, in view of the possibilities for abuse of finite insurance, failure to protect by means of standard insurance coverage further increases the need for full disclosure. b.

Yes, you should qualify your report. The firm is clearly disguising a loss

which has already occurred, by smoothing it over 5 years. Furthermore, the insurance premiums will be charged against operations, making it more difficult for investors to evaluate earnings persistence. You have 2 bases for your qualification. One is poor disclosure. You should insist that all aspects of the transaction be disclosed. The second is the credit of the policy payment received to current net income. This payment is more in the nature of a loan from the insurance company, repayable over 5 years. c.

Yes, it should be reported as a loan. While AIG was in the role of insurer

after assuming the finite insurance contracts from General Re, it bore no risk since any losses it pays would be deducted from the premiums to be refunded to the various finite insurance policy holders as their policies expire. Thus recognizing as revenue the $500 million from General Re violates the industry standard for revenue recognition. Total premiums exceed 90% of policy coverage and there is a zero (i.e., less-than-10%) probability of loss. Consequently, the $500 million was a loan from the various policyholders. d.

Such a new standard (i.e., a rule) may be difficult and controversial, since

it would be opposed by managers who would see their ability to manage earnings compromised. If the standard were implemented, management would likely seek ways to get around it. Consequently, it would be difficult and costly to enforce. Furthermore, there are many ways to manage earnings. If finite insurance was banned, firms would likely switch to some other method. 563 .

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Under a principles-based approach to standards, a general principle would be that firms should not mislead investors by means of artificial transactions designed to cover up losses and/or to opportunistically smooth earnings. Then, it would be up to the auditor’s professional judgement and ethical responsibility to qualify his/her report if the client insisted on such transactions. Presumably, under such a principles-based approach, the AIG auditor would not have accepted AIG’s original accounting, or any other accounting or transaction designed to mislead investors about AIG’s real reserves position 21.

Family control undoubtedly contributed greatly to the fraud. It

seems that Satyam management was able to control, or at least conceal important facts from, the Board of Directors, as evidenced by the Board’s approval of the plan to acquire the two family-owned companies. This control was likely aided by Mr. Rau’s brother, who was a managing director. Furthermore, it seems likely that non-family senior management was likely under family influence. Otherwise, it would have been difficult for Mr. Rau to have concealed a fraud as simple as creating false bank accounts and inserting false names onto the payroll. In this regard, Satyam’s director of internal auditing and its CFO were also arrested by Indian authorities. The agency problem that arises is that management of a family controlled company may work for the family rather than for all of the firm’s investors. This is a version of the moral hazard problem. As a result, minority investors will not invest in a family-controlled firm or will demand a higher return to accommodate for the increased estimation risk. A signal that a firm with concentrated ownership may adopt is to hire a prestigious auditor. This signal worked in this case, since the company’s rapid expansion, its awards for corporate governance and accountability, and its share listings in foreign countries suggest that investors perceived low estimation risk. b.

According to the power theory of executive compensation, a powerful

CEO can influence the board of directors. Even though several board members 564 .

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may be nominally independent, the CEO can influence their appointment. Furthermore, once appointed, even an independent director may feel that if he/she blocks family-oriented proposals, an anti-management reputation will quickly be acquired. Such a reputation will hamper his/her interaction with other directors and reduce the likelihood of appointment to other boards. c.

By definition, independent directors are not as familiar with the inner

workings of the firm as inside directors. Consequently, they are at an information disadvantage since they rely on management for much of the information they need to carry out their duties. However, management, and possibly inside directors, may supply incomplete or biased information to them. Information disadvantage does not completely explain the apparent failure of the independent directors to discover the fraud. They also have access to publicly available information about the firm, such as the financial statements and media reports. Yet, these directors apparently did not notice the large cash balances held in non-interest bearing accounts and the 2008 analyst report pointing these balances out. d.

Potential benefits to a country of adopting IASB accounting standards in

place of its local GAAP include better working capital markets, resulting in increased comparability of financial statements with other countries, lower cost of capital for firms, increased capital market liquidity and investment in the country and more efficient contracting. The extent of these benefits depends on the quality of local GAAP—higher quality, the less the benefits. Also, benefits will be reduced or eliminated in countries with weak capital markets regulations and enforcement .Poor regulation and enforcement may also allow companies to adopt IASB standards simply as a label. Such companies use the flexibility of GAAP to make few changes to their accounting under local GAAP. This fraud would likely have occurred under IASB GAAP. No set of standards can prevent outright fraud, such as management creation of false bank accounts and adding false employees to the payroll. However, the fraud would have been 565 .

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less likely if adoption of IASB GAAP was accompanied by increased disclosure regulation and enforcement, and improvements to corporate governance regulations.

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