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• Since GAAP requires considerable judgement in its application, other
Reasons to not go along:
• Deliberate GAAP violation is unethical. If discovered, this will lower your
reputation, the reputation of management and the company. Investors will
• If you go along, management’s opinion of you may actually decline. You
14. a. An auditor might be tempted to “cave in” to client pressure to manage
earnings for the following reasons:
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• GAAP are often vague and flexible about specific accounting procedures. For
allows the market to detect and evaluate earnings management policies in
the financial statements proper.
Longer–run costs to the auditor who yields to client pressure include:
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regulation is a reduction in the types of non–audit work the auditor can
undertake for the audit client.
Note: Increased regulation can also have benefits for the auditor. For
management, and that the audit committee be composed of independent
directors. In addition, the Act creates the Public Company Accounting
Oversight Board. This agency has the power to set auditing standards and
to inspect and discipline auditors of public companies. If it operates as it
should, future reporting scandals and resulting lawsuits will be reduced.
conservatism—Section 6.11). This would reduce auditor exposure to lawsuits
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since the auditor could claim that information predicting a business failure was
included in the balance sheet and income statement rather than in the notes,
feedback investors, who buy when share price starts to rise, and vice versa.
If earnings are BN, self–attribution biased investors do not lose faith in their
investment ability, in which case they would likely hold. If so, the market would
underreact to the BN. Thus self–attribution bias as a source of overreaction
seems only to operate for GN.
investor utility by more than it is increased by a corresponding increase in
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prospects. Then, we would expect a relatively strong market reaction if earnings
forecasts are not met. Since, in effect, investors have suffered a reduction in
on that day.
However, if we assume that market–wide effects were relatively small, note that
analysts’ estimates of Kodak’s earnings per share fell by .10/.90 = 11.1%.
Kodak’s share price fell by 9.25/(79. + 9.25) = 10.5%. Given that investors use
current earnings to revise their probabilities of future earnings, hence of future
15. Implications of the 2007–2008 market meltdowns for accountants include:
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• Transparency. Financial information should be transparent. Then,
investors will find the information useful for decision–making. Financial
avoid consolidation of off–balance sheet entities that held large amounts of
mortgage–backed securities and related financial instruments. Many of
these off–balance sheet entities were highly levered. Sponsors of these
entities usually gave explicit or implicit warranties that they would take
back these securities should the entity fail. As a result, the financial
that distressed market values (liquidity pricing) understated the future cash
flows of financial assets if they were held to maturity. Accountants came
under severe pressure from management, and governments, to remedy
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16. a. The calculation of economic profit by TD is related to the estimation of
firm value under clean surplus theory since they both involve the deduction of a
cost of capital charge from reported earnings, to arrive at abnormal earnings.
They differ, however, in the time periods to which they apply. Under the TD
economic profit approach, abnormal earnings are reported only for the current
invested capital is that that the bank regards income before amortization of
goodwill and intangibles as better measuring bank performance. Thus it adds
amortization back to economic income. But if goodwill and intangibles are not
amortized, the cost of these items must be regarded as part of capital, for
consistency.
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However, unrecorded goodwill exists only if future abnormal earnings are
positive. TD has not estimated these.
We may conclude that TD has unrecorded goodwill if it is able to continue
earning more than its cost of capital.
c. Either earnings number can be regarded as more useful.
on derivatives, preferred share redemption costs, etc. are not
indicative of manager performance. Net income includes these
items, and as such is a more comprehensive measure of
management performance.
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• To the extent that investors have limited attention, economic
income may be more useful since it removes the need for them to
make their own calculations. As a result, such investors will have a
better evaluation of firm performance than if only net income is
reported.
• Items of note may have low persistence. Then, ignoring them may
more useful, a reason is that intangible amortization and items of note are valid
expense items and are likely to recur. For example, management has paid for
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goodwill and other intangibles arising from acquisition of subsidiary companies,
be estimated, and is subject to error and possible manager bias.
The answer thus depends on whether the benefits of early revenue recognition
exceed the dangers of lower reliability. In retrospect, the reliability issue
dominates, since New Century’s allowance for credit losses of $13.9 million was
much too low.
settlements. This suggests deliberate management bias of the allowance
amount.
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At the risk of being naïve, some sympathy for management and auditor may
perhaps be warranted, since it is possible that they were caught up in the general
Since both retained interests and service rights would be backed up by contracts,
the value–in–use should be reasonably reliable (while these assets would be
subject to economy–wide risk, volatility due to risk is not the same as low
reliability). A reasonable answer is to agree with the company’s policy.
c. Yes. A more conservative allowance policy would be to record a higher