Accounting Theory

Session 3
Problem Set 5
Chapter 6
The Measurement Approach to Decision Usefulness

Adapted from Scott,

Financial Accounting Theory

Prof. Garen Markarian, PhD 1

 Problem Set 5
Question 1
1) Explain in your own words what “post-announcement drift” is.
Why is this an anomaly for securities market efficiency? Does post-
announcement drift necessarily imply that the average investor is
not rational?

Prof. Garen Markarian, PhD 2

 Problem Set 5
Solution 1 (1)
1) Explain in your own words what “post-announcement drift” is. (…)
Tendency for the share prices of firms that report GN or BN in quarterly
earnings to drift upwards or downwards, respectively, for a lengthy period
of time following the release of the earnings report.
It is known that quarterly seasonal earnings changes are positively
correlated. For example, the reporting of GN this quarter (compared with
the same quarter last year) increases the probability of reporting GN next
quarter as well. Thus, current quarterly earnings have two components of
information content. One component is their information content per se —
they provide current GN or BN that enables investors to revise their beliefs
about future firm performance. Second, they increase the probability of GN
or BN in future quarters, which will enable a further belief revision.
Prof. Garen Markarian, PhD 3
 Problem Set 5
Solution 1 (2)
1) (…) Why is this an anomaly for securities market efficiency? (…)
Because, to the extent that the drift is not explained by barriers to arbitrage
such as idiosyncratic risk or transactions costs, share prices should respond
immediately to all the information content of earnings, according to the
theory. However, this does not seem to happen. Instead, the market takes a
lengthy period of time to figure this out or, alternatively, it waits until the
current implications are validated in subsequent quarterly reports.

Prof. Garen Markarian, PhD 4

 Problem Set 5
Solution 1 (3)
1) (…) Does post-announcement drift necessarily imply that the
average investor is not rational?
It may or may not imply non-rational investors. On the one hand, it could
be driven by behavioural biases such as conservatism or limited attention.
On the other hand, according to the arguments of Brav and Heaton, it could
be driven by the uncertainty of rational investors about whether the firm’s
expected earning power has in fact increased (for GN) or decreased (for
BN). In the face of this uncertainty, investors attach some probability to
this possibility and some probability to the possibility that the GN or BN is
a random event, and thus of low persistence. To determine which
possibility is correct, investors monitor subsequent events, revise their
probabilities over time as new evidence appears. These revisions will
produce an upward or downward drift in share price over time.
Prof. Garen Markarian, PhD 5
 Problem Set 5
Question 2
2) Explain in your own words why the market response to accruals, as
documented by Sloan (1996), is an anomaly for securities market
efficiency.

Prof. Garen Markarian, PhD 6

 Problem Set 5
Solution 2 (1)
2) Explain in your own words why the market response to accruals, as
documented by Sloan (1996), is an anomaly for securities market
efficiency.
The efficient market will respond more strongly to the GN or BN in
earnings (i.e.: a higher ERC) the greater is the persistence of the GN or BN.
Cash flows are more persistent than accruals since accruals are more
subject to errors of estimation and possible manager bias than cash flows,
thereby reducing the association between current accruals and next period’s
net income. Operating cash flows are not subject to this reversal
phenomenon. Sloan checked this argument for his sample firms and found
that cash flows were indeed more persistent than accruals.

Prof. Garen Markarian, PhD 7

 Problem Set 5
Solution 2 (2)
2) Explain in your own words why the market response to accruals, as
documented by Sloan (1996), is an anomaly for securities market
efficiency.
This being the case, the efficient market will respond more strongly to a
dollar of abnormal earnings if it comes from operating cash flows than if it
comes from accruals (recall that net income equals operating cash flows
plus or minus net accruals). Sloan found that while the market did respond
to the GN or BN in earnings, it did not respond more strongly when there
was a greater proportion of cash flows to accruals in earnings. This is an
anomaly because a differential response is predicted by efficient securities
market theory.

Prof. Garen Markarian, PhD 8

 Problem Set 5
Question 3
3) A firm is expected to earn $100 net income for next year, at the end
of which time the firm will be wound up. The $100 expected
earnings includes gains and losses from disposals of assets and
liabilities, and all other winding up costs. The firm’s book value at
the beginning of the year is $500, and its cost of capital is 14%.
What is the firm’s market value as at the beginning of the year?
a. $526.32
b. $570.00
c. $587.72
d. $600.00

Prof. Garen Markarian, PhD 9

 Problem Set 5
Solution 3 (1)
3) (…) What is the firm’s market value as at the beginning of the year?
According to clean surplus theory, the firm’s opening market value is:

𝑃𝐴! = 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 + 𝑃𝑉 𝑜𝑓 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑓𝑢𝑡𝑢𝑟𝑒 𝑎𝑏𝑛𝑜𝑟𝑚𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠

!""#".!%∗'""
= 500 + !.!%
("
= 500 +
!.!%
= $526.32

Prof. Garen Markarian, PhD 10

 Problem Set 5
Solution 3 (2)
3) (…) What is the firm’s market value as at the beginning of the year?
Note:
Many students answer this question as $500 + 100/1.14 = $587.72. This is
incorrect as it ignores the fact that firm value consists of net assets as per
the balance sheet plus the discounted present value of expected future
abnormal earnings. Failure to deduct a capital charge overstates firm value,
since the market expects the firm to earn its cost of capital on opening
investment, and only includes in goodwill value the abnormal portion of
future earnings. To put this another way, the $500 book value of the firm’s
assets would have to be written down if they could not earn cost of capital,
according to ceiling test standards.

Prof. Garen Markarian, PhD 11

 Problem Set 5
Question 4 (1)
4) You are the senior accountant of a large, publicly traded company
that is experiencing a decline of business that management feels is
temporary. To meet earnings projections given in its previous year’s
MD&A, management asks you to find an additional $5 million of
reported earnings for the current year. After some study, you
determine that to increase earnings by this magnitude, it is
necessary to recognize additional revenue on contracts in process,
even though the contracts are far from completion and it is
questionable whether or not any profits will actually be realized. A
careful study of accounting standards relating to revenue
recognition leads you to the conclusion that to recognize $5 million
of profits at this stage would not be in accordance with GAAP.
Consequently, the auditors will be expected to object.
Prof. Garen Markarian, PhD 12
 Problem Set 5
Question 4 (2)
4) You report this to management, but are instructed to proceed
anyway. Management assures you that next year’s business will be
much better and the premature revenue recognition will never be
noticed. Furthermore, management is sure it can convince the
auditor of this as well.
Required:
What will you do in response to this ethical dilemma? Give reasons
for and against your decision.

Prof. Garen Markarian, PhD 13

 Problem Set 5
Solution 4 (1)
4) Required:
What will you do in response to this ethical dilemma? Give reasons
for and against your decision.
Your decision is whether or not to go along with management’s request
Reasons to go along (1):
• If you do not go along, you may suffer demotion or be fired, or be forced to resign.
In contrast, if you go along, you will possibly earn management’s approval and
consequent rewards.
• Recognizing revenue early increases earnings relevance, since investors get an
earlier reading on future firm performance.

Prof. Garen Markarian, PhD 14

 Problem Set 5
Solution 4 (2)
4) Required:
What will you do in response to this ethical dilemma? Give reasons
for and against your decision.
Reasons to go along (2):
• If business picks up next year, the early revenue recognition this year may never be
noticed, since reduced revenue recognized next year (as current year’s revenue
accruals reverse) will be outweighed by revenue from new business.
• Since GAAP requires considerable judgement in its application, other expert
accountants and auditors may conclude that, despite your reservations, the extra
revenue recognition does not really violate GAAP under the circumstances.
• If the auditor goes along with management’s request, you can blame the auditor
should the early revenue recognition be discovered.

Prof. Garen Markarian, PhD 15

 Problem Set 5
Solution 4 (3)
4) Required:
What will you do in response to this ethical dilemma? Give reasons
for and against your decision.
Reasons to not go along (1):
• Deliberate GAAP violation is unethical. If discovered, this will lower your
reputation, the reputation of management and the company. Investors will lose
confidence and share price will fall.
• If you go along, management’s opinion of you may actually decline. You could be
viewed as easily manipulated and of low standards. This would increase the
likelihood of similar demands in future.
• Early revenue recognition lowers earnings reliability. There is a substantial
probability that actual earnings on the contracts in process will differ from the
amounts currently projected.
Prof. Garen Markarian, PhD 16
 Problem Set 5
Solution 4 (4)
4) Required:
What will you do in response to this ethical dilemma? Give reasons
for and against your decision.
Reasons to not go along (2):
• Management’s optimism may prove to be unfounded, and next year’s business may
not pick up. This increases the probability that the early revenue recognition this
year will be discovered.
• Should the auditor not go along, you, management, and the company will become
involved in extensive arguments and negotiations with the auditor. This will be
costly, time-consuming, and may lead to auditor resignation or a qualified audit
report, with attendant bad publicity.

Prof. Garen Markarian, PhD 17