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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
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 3
121
(i.e., they exclude) the original investment.
State
H L
a1 $324 $ 0
Act
a2 $ 36 $36
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
H 0.6 0.4
State
L 0.1 0.9
Good evidence means that a company reports increased profits and
adequate working capital. Bad evidence means that the company’s
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122
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.
123
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.
b. 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
124
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.
125
To illustrate, suppose that the banker has square root utility. The
expected utility of the gamble is:
64.848.53.0107.0303.01007.0)30,$100($ =×+×=×+×=EU
Whereas the utility of the expected value of the loan is
89.879)79(==U
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:
64.8)( == xxU
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
126
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.
6.3
0182.0
08.03242.0)(
1
=
+×=
+=aEU
6
36
368.0362.0)( 2
=
=
+=aEU
The investor should take a2.
b. By Bayes theorem:
127
6.0
20.
12.
08.12.
12.
1.08.06.02.0
6.02.0
)/()()/()(
)/()(
)/(
=
=
+
=
×+×
×
=
+
=
LGPLPHGPHP
HGPHP
GHP
Thus P(L/G) = 1– 0.6 = 0.4
Then,
6
36)(
8.10
0186.0
04.03246.0)(
2
1
=
=
=
+×=
+=
aEU
aEU
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,
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.