Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 5
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
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
175
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
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
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 5
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
Then, P.V. Ltd.’s net income under historical cost accounting with straight–line
amortization is:
YEAR 1 YEAR 2 TOTAL
Sales (incl. interest on
opening cash)
$150.00 $165.00 $315.00
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Under present value accounting as per Example 2.1 we have economic income
as accretion of discount:
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
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)
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.
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c. 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
d. Investors usually cannot wait until the firm is wound up in order to know
16. a. Expected utility of each act, based on Leo’s prior probabilities:
5.18
5.315
57.0503.0
257.025003.0)(
1
=
+=
×+×=
+=aEU
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179
15
=
Leo should take a1.
b. By Bayes theorem:
12.
8.07.04.03.0
4.03.0
)/()()/()(
)/()(
)/(
×+×
×
=
+
=
LBPLPHBPHP
HBPHP
BHP
d. Possible reasons for positive market response:
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180
• 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.
17. a. The initial rise in Canadian Tire’s share price occurred for 2 reasons:
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181
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.
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 5
182
Scott, Financial Accounting Theory, 7th Edition Instructor’s Manual Chapter 5
a 2
08.04002.0)(
1
×+×=aEU
The expected return on Imperial stock, from the market model, and using the
theoretical relationship αj = Rf (1 – βj), was
Abnormal return was thus:
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