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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

which could cause a share price decline.

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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

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

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all shares as potential lemons. From society’s perspective, this is

undesirable since the efficiency of capital allocation is reduced.

A superior answer will point out that the longer–run arguments against sale above

reinforce the ethical argument against sale.

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

Failure to forecast can have a negative impact on the working of securities

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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,

12. a. 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

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,

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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

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.

13. a. 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

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.

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b. 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

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

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

contract once the contract is signed, assuming that information about the

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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

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

15. 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.

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.

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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

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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b. 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 post–

mortem, 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

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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.)

b. 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.