978-0132984669 Chapter 11 Part 4

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 11

income taxes 19

2,503

(117)

c. 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.

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bogey of the bonus plan. In the case of ACR, however, no unusual, non–

recurring 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.

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

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 11

c. 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.

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

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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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11A-4. a. 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

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

c. The answer depends on the extent of securities market efficiency. Given full

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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

b. The importance of meeting earnings targets derives from securities market

efficiency and rational investor behaviour. A firm’s share price will incorporate the

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11A-6 a. 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.

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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.

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

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• Cleaning house. The market may have felt that the writedown signals that

b. Reasons why the bank may have wanted to take a bath:

c. 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.

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d. 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

You would object to this suggestion, for the following reasons:

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.

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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.