Chapter 8—USEFULNESS OF ACCOUNTING INFORMATION TO INVESTORS AND CREDITORS
TRUE/FALSE
1. The FASB has implicitly adopted the cash flow valuation model.
2. The FASB maintains that accrual accounting systems are more useful for predicting net cash
flows than are simpler cash-based systems.
3. The value to investors of the information in financial reporting lies in its role as an historical
record.
4. Residual income refers to income in excess of a charge for the capital that is employed to
generate that income.
5. Economic profit is equal to net operating profit less taxes paid minus a charge on invested capital.
6. Economic profit is sometimes referred to as abnormal earnings.
7. According to the clean surplus accounting, ending book value of equity equals beginning book
value plus earnings.
8. The underlying premise of the clean surplus accounting is that all profit and loss elements go
through income.
9. Residual income can be used as a company and intra-company performance measurement tool.
10 . The calculation of residual income recognizes that equity, but not debt, has a cost.
11. Economic income is equal to residual income.
Accounting Theory: 8th edition Page 2 of 12
12. Unlike stock price, which is forward looking, residual income focuses on historical performance.
13. The efficient-markets hypothesis refers to the speed with which financial analysts are able to
predict a firm’s cash flows.
14. Most testing of the efficient-markets hypothesis has dealt only with past information reflected in
security prices.
15. The theoretical foundation of capital market or security price research comes from the efficient-
markets hypothesis.
16. According to portfolio theory, systematic risk can be reduced by holding a portfolio of
investments.
17. The expected portfolio return decreases as risk increases.
18. In portfolio theory, systematic risk is defined as the variance of expected investment returns.
19. The assumption of the capital asset pricing model is that individual securities are priced solely on
unsystematic risk.
20. In the capital asset pricing model, beta is used to represent systematic risk of individual securities
and to predict the risk-based price of securities.
21. The relationship between risk and return for diversified portfolios is modeled by the Security
Market Line (SML).
22. The strongest evidence from capital market research concerns the information content of annual
accounting earnings numbers.
Accounting Theory: 8th edition Page 3 of 12
23. Capital market research has shown that investors do not appear to adjust accounting income to
compensate for artificial bookkeeping differences.
24. Research studies have predominantly supported the naive-investor hypothesis.
25. When accounting numbers are used to monitor agency contracts, there can be indirect
consequences from changes in accounting policies.
26. The study by Lev that examined earnings numbers and stock returns found a high explanatory
relationship between earnings and stock returns.
27. The study by Ou and Penman, which used traditional accounting measures to predict whether a
company’s income would increase or decrease, indicated that markets are not as efficient as
previously thought, and that fundamental analysis is important for investment purposes.
28. Post-earnings-announcement drift refers to the fact that it takes up to 90 days for security prices
to react significantly to earnings announcements.
29. Because post-earnings-announcement drift shows that there is at least some amount of efficiency
in the market, it is even more important to attempt to improve the quality of accounting
standards.
30. The usefulness of accounting information may be determined by directly asking investors how
they use annual reports.
31. Surveys of individual investors have generally indicated a high readership of accounting
information.
32. It may be assumed that accounting information has no usefulness to investors because many
individual stockholders do not read annual reports.
33. Accounting information ranks at the top on surveys that ask investors to weigh the importance of
different types of investment information.
34. Accounting-based ratios have not been very useful in discriminating between firms that
subsequently went bankrupt and those that did not.
35. The relationship between earnings and stock prices has diminished over the years, but the ability
of earnings to forecast futures cash flows has not.
MULTIPLE CHOICE
1. Which of the following is not a true statement?
a.
There is empirical evidence that future cash flows are better forecasted with accrual data
than with cash flow data.
b.
Accrual accounting numbers incorporate the attribute that determines firm valuation-net
cash flow data.
c.
Changes in reported accounting earnings affect firm valuation through changes in stock
prices.
d.
The value to investors of the information in financial reporting lies in its role as an
historical record.
1. Which of the following is not true regarding earnings and dividends?
a.
Managers adjust dividends primarily to reflect the change in current earnings.
b.
Stock price may be modeled as the present value of future expected dividends.
c.
Investors regard cash dividends as credible signals of future performance.
d.
Current income has a value in predicting future dividends.
2. Which of the following is true regarding the term residual income?
a.
Residual income is the income over and above the amount needed to cover current
expenses.
b.
Residual income is the income in excess of a charge for the capital that is employed to
generate that income.
c.
Residual income is equal to economic income.
d.
Residual income is called abnormal earnings when applied to the enterprise’s operating
income and invested capital.
3. Excess income over and above the expected amount of after-tax operating income is called:
a.
Extraordinary Profit
b.
Remaining Profit
c.
Economic Profit
d.
Monetary Profit
4. Which of the following would be an argument in favor of using residual income models in
performance measurement?
a.
All forms of residual income are consistent with discounted net cash flows for any method
of depreciation.
b.
Residual income focuses on historical performance.
c.
The determination of residual income is dependent on an accurate estimate of the cost of
capital.
d.
Residual income recognizes that all capital, debt as well as equity, has a cost.
5. Which of the following applies to the clean surplus theory?
a.
It is a theory that is applied to security valuation, but is not very attuned to accounting
concepts and numbers.
b.
The theory values a firm’s equity based on the beginning of the period book value plus the
present value of expected future abnormal earnings.
c.
The theory considers a firm’s abnormal earnings amount to be equal to its beginning of the
period book value multiplied by the cost of equity capital.
d.
This theory does not tie in well with the FASB’s concept of comprehensive income.
6. Which of the following would give rise to abnormal earnings?
a.
Accelerated depreciation
b.
LIFO costing for inventories and cost of goods sold
c.
Immediate write-off of research and development
d.
All of the above
7. Which of the following are possible sources of abnormal earnings?
a.
Recognizing the positive excess present value above the cost of a project on the balance
sheet
b.
The use of current values in reporting marketable securities
c.
Conservative matching and recognition procedures under historical costing
d.
All of the above
8. The three forms of the efficient-markets hypothesis are:
a.
Weak, semistrong, strong.
b.
Slow, quick, instantaneous.
c.
Past, current, future.
d.
Private, semipublic, public.
9. Which of the following statements does not apply to portfolio theory?
a.
It is the foundation for the capital asset pricing model.
b.
It is the foundation for capital market or security price research.
c.
It holds that risk can be eliminated by holding a portfolio of investments.
d.
It is a theory of rational investment choice and utility maximization.
10. Which of the following statements applies to the capital asset pricing model?
a.
It assumes that individual securities are priced solely on unsystematic risk.
b.
It uses beta to represent unsystematic risk of individual securities.
c.
It assumes that if the rate of return on an individual security is greater than the market
average, systematic risk of the security must be smaller.
d.
It assumes that if beta equals 1, the systematic risk of an individual security is equal to the
average risk of the market as a whole.
11. Which of the following statements does not apply to the market model?
a.
It is a simpler approach than the standard version of the capital asset pricing model.
b.
This approach is seldom used in accounting research.
c.
In this model, the risk-free return is dropped from the equation.
d.
Abnormal returns are captured in the error term of the model.
12. Which of the following is a finding of previous capital market research studies?
a.
The market is not fooled by arbitrary accounting numbers.
b.
The direction of change in reported accounting earning is inversely correlated with
security price movements.
c.
The market is affected by alternative accounting income numbers that do not affect cash
flow, such as those related to a change from deferral to recognition of unrealized holding
gains on marketable securities.
d.
Security prices are affected by a change from the deferral to flow-through method of
accounting for the investment credit.
13. In security-price research, which of the following is an indirect consequence of an accounting
policy change?
a.
The value of the firm is affected through an effect on cash flow.
b.
The value of the firm is affected through an effect on net income.
c.
The value of the firm is affected through an effect on owners.
d.
The value of the firm is not affected.
Chapter 8—USEFULNESS OF ACCOUNTING INFORMATION TO INVESTORS AND CREDITORS
Accounting Theory: 8th edition Page 7 of 12
14. Which of the following findings would support the naive-investor hypothesis?
a.
A finding that security prices respond to income levels that differ solely because of
alternative accounting methods with no cash flow consequences
b.
A finding that security prices do not respond to artificial book-income differences
c.
A finding that security prices do not respond to the adoption of LIFO for accounting for
inventories and cost of goods sold
d.
A finding that security prices do not respond to a change in reported accounting earnings
from the prior year
15. Which of the following is a possible reason why security prices were found to respond to changes
from pooling to purchase accounting for combinations?
a.
A change from pooling to purchase accounting does not affect cash flow
b.
Differences between purchase and pooling accounting affect only book income
c.
The change could have affected dividend distribution because of debt covenants
d.
Income would normally be higher under purchase accounting than pooling
16. Which of the following is an assumption of fundamental analysis?
a.
Securities markets are efficient.
b.
Prices of securities rapidly reflect all publicly available information.
c.
The strong form of the efficient-markets hypothesis is true.
d.
Under-priced shares can be found in the securities market by means of financial statement
analysis.
17. Which of the following is not a finding or conclusion of the research study by Ou and Penman
that used traditional accounting measures to predict whether a company’s income would increase
or decrease?
a.
The researchers were unable to describe the following year earnings changes correctly in
most cases.
b.
Markets are not as efficient as efficient-market advocates would like to believe.
c.
Better accounting standards might improve the predictive ability of accounting
information.
d.
Fundamental analysis is still important for investment purposes.
18. Which of the following statements does not apply to the study by Lev that examined earnings
numbers and stock returns?
a.
According to Lev, over time, the correlation between earnings numbers and stock returns
has been low.
b.
Lev believed that earnings have very little explanatory power relative to changes in stock
prices.
c.
Lev believed that one of the primary reasons for the level of correlation between earning
and stock returns lies with the low quality of reported income numbers.
d.
The study’s results contradicted those of the Ou and Penman study.
Accounting Theory: 8th edition Page 8 of 12
19. Which of the following statements is true regarding post-earnings-announcement drift?
a.
Security prices do not react significantly at the time of earnings announcements.
b.
At least part of the blame for this effect has been laid at the feet of financial analysts.
c.
This effect is more important for larger firms than for smaller firms.
d.
Security prices never fully reflect the effects of earnings announcements.
20. Which of the following is not a possible cause of post-earnings-announcement drift?
a.
Financial analysts overreact to fundamental signals stemming from securities.
b.
Shareholders do not distinguish well between the cash flow portions and the accrual
portions of earnings.
c.
Financial analysts’ forecast errors lead to incomplete security price adjustments.
d.
Transaction costs are too high relative to the potential gain that can be earned from the
mispricing of the securities.
21. Which of the following is not true regarding capital market research?
a.
Studies have found a low correlation between the variability of accounting earnings and
beta.
b.
Studies have found a strong association between accounting-based ratios and the market
measure of risk.
c.
Studies have found that supplemental segment (line of business) disclosures resulted in a
revision of systematic risk, indicating that such information is useful for risk assessments.
d.
At least one study has found that pension information is not useful for risk assessments.
22. Which of the following statements is not supported by empirical evidence from capital market
research?
a.
Accounting earnings appear to have information content and to affect security prices.
b.
Alternative accounting policies with no apparent direct or indirect cash flow consequences
to the firm do not seem to affect security prices.
c.
There are no incentives to choose certain alternative accounting policies over others
because there are never cash consequences.
d.
Accounting-based risk measures correlate with market risk measures, suggesting that
accounting numbers are useful for risk assessment.
23. Early advocates of security-price research now recognize there are limitations to this research for
use in choosing the best accounting policies and evaluating the economic consequences of
alternative accounting policies on security prices. Which of the following is not a reason for
these limitations?
a.
The public-good nature of accounting information
b.
The existence of free riders
c.
The resultant market failure in terms of optimal resource allocation
d.
The use of historical costing distorts financial statement amounts
Market efficiency means that (1) the market fully reflects available information, and
(2) by implication, market prices react instantaneously to new information.
new information.
24. Which of the following ranks below annual reports on surveys that ask investors to weigh the
importance of different types of investment information?
a.
Information from company reports
b.
Information about general economic conditions
c.
Company announcements on products and markets
d.
None of the above rank below annual reports
25. The research approach that examines the association between accounting data reported in annual
financial statements and the levels of stock prices is called:
a.
Cross-sectional valuation
b.
Investor survey analysis
c.
Accounting information usefulness research
d.
Time series analysis
26. Which one of the following statements is not part of the incomplete revelation hypothesis (IRH)?
a.
Some accounting numbers or relationships may not be fully revealed in security prices.
b.
Footnote disclosure is all that is needed for information to fully impact security prices.
c.
Some individuals’ trading habits do not respond in a rational way to new information.
d.
Some individuals respond to information is such a way as to impede the market from
acting in a fully efficient manner.
ESSAY
1. What is the underlying premise of clean surplus theory and how is it applied in determining the
valuation of a firm’s equity?
2. Respond to the following:
a.
What is meant by market efficiency?
b.
What does the efficient-markets hypothesis imply about the value of accounting
information?
c.
Describe the three forms of the efficient-markets hypothesis.
3. Respond to the following:
a.
Describe the capital asset pricing model.
b.
What is the market model?
the market.
beta, and the expected return on the market portfolio.
abnormal) returns for any time period are captured in an error term.
4. What are the weaknesses of capital market research?
says that prices reflect all information (both public and private).
5. Discuss whether alternative accounting policies have a systematic effect on security prices and
what this implies about the information content of accounting policy changes. Include a
discussion of previous research in this area.
6. What is post-earnings-announcement drift, and what are possible causes for this phenomenon?
7. What is cross-sectional valuation and how has this approach been used in research studies?
8. Discuss the results of the study by Loh and Mian as they relate to the importance of earnings
forecasting.