Accounting Theory Conceptual Issues in A Political and Economic Environment 9th Edition Wolk Solutions Manual 1

Chapter 8: Usefulness of Accounting Information Instructor Manual
ACCOUNTING THEORY CONCEPTUAL

ISSUES IN A POLITICAL AND ECONOMIC
ENVIRONMENT 9TH EDITION WOLK
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Chapter Highlights
Chapter 8 is concerned with the usefulness of external accounting reports for decision making.
The FASB emphasizes decision usefulness in both the conceptual framework project and in
policy deliberations for specific standards. Therefore, it is possible to judge (to some extent) the
benefits of external accounting reports by evaluating their usefulness to investors/creditors, the
FASB’s primary user group.
There are two distinct ways in which the research should be considered. First, it provides a basis
for evaluating the present usefulness of accounting. Second, the research methods themselves
represent techniques and approaches that may be applied in an ongoing way to assess the
usefulness of future or alternative accounting policies. In other words, “economic
consequences” of accounting regulation can be investigated through the research approaches
discussed in the chapter. Clean surplus theory is a new valuation approach which may help
researchers in assessing the relationship between firm valuation and accounting information.
“Benefits” are the focus of the chapter. Questions of costs and the apportionment of costs are
equally important. Some of the recent capital market research has focused on questions of how
accounting policies affect owner wealth. These studies are often cast in terms of agency theory,
and consider the “costs” of accounting policy changes in terms of their wealth impact on owners.
Accounting Theory (9th edition) Page 1 of 18
However, the evidence on economic consequences is largely one-sided, focusing on benefits
(e.g., information content) rather than costs. This point should be emphasized and related back
to the question of determining optimal regulation (raised in Chapter 4). All of the research is
empirical except information “economics,” which is included because decision theory illustrates
how information has value in an uncertain decision setting.
Capital market research dominates the empirical literature, which is reviewed. This is
appropriate given its influence over the past 40 years. Other research is important, though it
suffers from some methodological problems such as reliability (surveys) and lack of generality
(experimental research). Another area of research mentioned in the text is the bond rating and
bond risk premium literature (creditors). This research has considered the effects of accounting
numbers and ratios on creditor lending decisions. It too supports the usefulness of accounting
information for decision making. The role of the auditor in terms of providing assurance to users
is also briefly discussed.
One point that is becoming clear is limitations on the efficient markets hypothesis. This point
arises in relation to post-earnings – announcement drift which has been determined from
empirical research and the incomplete revelation hypothesis which is a deductive hypothesis.
Combining these with empirical studies by Ou and Penman also showing that the market is not
as efficient as we might believe and Lev’s study showing low correlation between earnings
numbers and stock returns and the door is certainly open for putting time and effort into
improving accounting standards.

Questions
Q-1 How is accounting data useful to investors? To creditors?
The financial economics valuation models reviewed in the chapter suggest that accounting
reports are useful in assessing a firm’s future cash flows. This is consistent with SFAC No. 1,
which views the role of accounting reports as aiding in assessing the amounts, timing, and
uncertainty of prospective cash flows. Beaver’s work, while similar in spirit, sees the linkage as
less direct—current earnings predict future earnings, which in turn determine dividend-paying
ability. The difference is that the former view sees a firm’s value as a function of future cash
flows, and the latter sees it as a function of future expected dividends.
Theory is less well developed with respect to the valuation of debt and the role of accounting
information. The work reviewed in the chapter indicates that debt interest rates reflect a risk
premium for the possibility of default. Therefore, the usefulness of accounting lies in aiding
creditors to assess the likelihood of default. In very broad terms, this concern leads to an interest
in future cash flows, viz., debt-servicing ability and the ability to repay or refund the principal
amount of the debt. Hence, information to investors and creditors is complementary. Finally,
both would be interested in accountability aspects of financial statements.
Q-2 In what ways do you think information useful for investors (in assessing future cash
flows) differs from that useful for creditors (in assessing default risk)?
In general, investors and creditors are interested in the amounts, timing, and uncertainties of a
firm's expected future cash flows. Cash payments to equity holders are theoretically unlimited,
and the focus is typically on the upside potential of the expected future cash flows. In contrast,
the cash payment for debt securities is fixed by contract. Hence, the usefulness of accounting
information for creditors lies in its ability to predict the failure of a borrower to make timely
payment of interest and principal. Furthermore, the likelihood of default affects the default risk
premium, which in turn affects the rate the borrower is charged. Finally, we note that interest
bearing debt securities trade infrequently. As a result, theories underlying the usefulness of
accounting information to creditors are not as well developed as they are for equity securities.
Q-3 Besides the primary investor-creditor group, what other user groups could claim to be
stakeholders in the firm? How might their information needs be the same as the the
primary investor-creditor group? How might their information needs differ?
Any individual or entity whose income or payments are affected by a firm's financial wellbeing
has stake in the firm. This would include taxing authorities, utility ratepayers, suppliers of
materials and services, and even current or potential employees. To varying degrees, all of these
stakeholders have an interest in forecasting the expected future cash flows, and in assessing the
firm's financial wellbeing. Their respective information needs depend on the nature of the
explicit or implicit contract. For example, income taxing authorities have a lot in common with
shareholders; their receipts are more directly related to the firm's performance. In contrast,

employees or utility rate payers, at least in the short-term, have contracts that provide for fixed
receipts or rate payments. As such, the needs of these individuals might more closely be related
to creditors.
Q-4 Who are creditors?
Creditors are mainly considered suppliers of materials, services, or capital. They need financial
information about their customers to determine the terms of credit.
Q-5 Why do we sometimes say that the dividend discount model is actually an earnings
model? How does Lintner’s findings relate dividends and earnings?
The dividend discount model is a mathematical model that expresses the value of a stock as the
present value of the expected future dividends. Since dividends are considered to be paid from
earnings, the dividend discount model can be rearranged to express the value of a stock in terms
of the expected future earnings per share and the dividend payout ratio.
Lintner interviewed a number of managers regarding how the managers make a decision
regarding the payment of a cash dividend. Managers indicated that major changes in
"permanent" earnings were the most important determinants of the companies' dividend
decisions. Managers adjusted dividends to reflect expected changes in "permanent" earnings.
Given the seriousness and forward-looking nature of the dividend policy decision, investors
regard cash dividends as credible signals of future performance. A change in the cash dividend
has information content.
Q-6 What is residual income? Abnormal earnings? Economic profit? EVA?
Residual income is a general term for income in excess of a charge for the capital employed to
generate that income. The concept may be applied to the enterprise as a whole or to the firm’s
common equity. When applied to the enterprise’s operating income and invested capital, residual
income is often called economic profit or Economic Value Added (EVA®). When applied to the
firm’s net income and common equity, residual income is often called residual income or
abnormal earnings.
Q-7 How does EVA differ from economic profit?
Economic Value Added (EVA) is a proprietary form of economic profit developed by Stern
Stewart & Co. EVA begins with residual income [economic profit] and makes a series of
additional adjustments to GAAP accounting that are intended to produce a "better" estimate of
economic profit.

Q-8 What are some advantages and disadvantages of using residual income (including
economic profit and EVA) for performance measurement?
On the positive side, residual income can be used as a company and intra-company performance
measurement tool. It recognizes that capital has a cost. Making capital an explicit part of the
model raises the awareness of using excess capital to generate income; capital has a cost. In
addition, residual income has been shown to have more explanatory power than reported
earnings or cash flow from operations. It can also be used for valuation purposes. On the
negative side, for any given year, the determination of the residual income itself is dependent on
an accurate estimate of the cost of capital. And for valuation purposes, forecasts are crucial.
All forms of residual income are consistent with discounted net cash flows for any book value
and any method of depreciation. Lengthening the depreciable life for fixed assets decreases the
per-period depreciation expense, increases NOPAT, and increases the residual income. In some
cases, it may not be possible to determine whether the residual income calculated is actually due
to management’s efforts or lack thereof.
Residual income is an accounting measure and can be manipulated for any one period.
Furthermore, if improperly applied, residual income could bias management against long-term
investments. Unlike the stock price, which is forward looking, residual income focuses on
historical performance.
Finally, it is not clear that residual income leads to improved stock performance
Q-9 Comment on the following statement. “The residual income model is no different from
the dividend discount model. Therefore, it has no value to investors and analysts.”
The residual income model is consistent with the dividend discount model. However, this does
not mean that it has no value. As indicated above, it can be used as a performance measurement
tool. Unlike net income, residual income recognizes that capital has a cost. Furthermore, residual
income has been shown to have more explanatory power than reported earnings or cash flow
from operations. Finally, Dechow, Hutton and Sloan have shown that the residual income model
allows the user to incorporate non-accounting information into the model to improve its
accuracy.
Q-10 Comment on the following. “Maximizing residual income is the same as maximizing
earnings. Managers should be rewarded for maximizing either one.”
Managers can increase earnings by increasing the amount of capital employed. On average,
investing in more assets translates to increased earnings. The problem is that there is no
guarantee that the additional capital employed is earning its cost of capital. If not, deploying
additional capital is destroying shareholder wealth, similar to investing another $1.00 to gain an
additional $0.80 of intrinsic value.

In contrast, residual income explicitly recognizes that capital has a cost. Managers can only
increase value if they increase income above and beyond that which is required for the amount of
capital employed. Managers should not be rewarded for maximizing earnings if the capital
employed is not earning its cost of capital.
Q-11 Why do managers of Berkshire Hathaway have an incentive to send cash to Omaha?
Managers at Berkshire Hathaway are charged a high rate for the incremental capital that they
employ. If they can generate income in excess of that capital charge, they create value and are
rewarded. If not, they destroy value, and are penalized accordingly. Implicitly, this is an
application of residual income model.
If managers are not able to use the incremental capital to create value, they have a strong
incentive to lower their invested capital and capital charge by sending the cash to Omaha
(Warran Buffett). This lowers or eliminates any penalty. Cash that cannot be profitably invested
is given to Warren Buffett who distributes it to the individuals who are best able to invest it.
Q-12 Should firm’s capitalize research and development expenditures? Why or why not?
Research and development expenditures are cash outflows. If they are expected to generate
future income, one can make an argument that these expenditures are really investments, which
should be capitalized. This is exactly what is done when firms use EVA. The problem is that
there is less certainty about future income from R&D than there typically is with investments in
other tangible assets. In the worst case, one can easily envision a case in which a firm capitalizes
worthless R&D in order to lower operating expenses and increase reported income.
Q-13 What is clean surplus accounting? What is its role in linking dividends and abnormal
earnings?
Clean surplus accounting is a term indicating that all profit and loss elements go through income.
It relates the current book equity to previous book equity, earnings, and dividends. In the
presence of clean surplus accounting, the residual income model is equivalent to the dividend
discount model.
Q-14 What is the efficient-markets hypothesis?
In its simplest form, the efficient-markets hypothesis states that information is quickly
“impounded” in security prices. Market efficiency refers to informational efficiency, not to social
efficiency (in a Pareto sense).

Q-15 Why does the concept of market efficiency (with respect to information) have no
necessary relation to the quality of accounting information? Why is this distinction
important with respect to accounting policy making?
Market efficiency refers only to the speed with which new information is incorporated into
security prices. It says nothing about the quality of the underlying information. Although, in the
extreme case, if the “information” were purely noise, one would not expect to
Q-16 Why is the efficient-market hypothesis being challenged?
Numerous market anomalies have been reported. The Ou and Penman study, among others,
raises the question of whether all publicly available information is really impounded in security
prices. Also, post-earnings-announcement drift raises the question of why it takes up to 60 days
for earnings announcements to be impounded in security prices. This may be due to transaction
costs being too high for investors to take advantage of new information or possibly to
underreaction to new information by security analysts.
Q-17 What is meant by “information content” and how does capital market research
determine the information content of accounting numbers?
Information content is a term referring to abnormal security returns in response to the release of
new, publicly available information. The research method is described in the chapter. There are
two distinct problems with this research. The first relates to the implicit dual testing for both
market efficiency (the efficient-market hypothesis) and information content (given an
assumption of market efficiency). The second relates to the difficulties in applying asset pricing
models, or even knowing if the asset model used is correct.
Q-18 What is the advantage of being well diversified? Is there a downside? Why or why
not?
There are two types of risk. The risk associated with an individual firm or entity is called
unsystematic (diversifiable, unique) risk. This risk can be eliminated with diversification. The
remaining portfolio risk is called systematic (undiversifiable, market) risk. Systematic risk is also
known as the relevant risk as this risk must be borne by the investor.
Diversification does reduce the investor's risk. However the more securities or assets that are
added to an investor's portfolio, the less the investor is able to meaningfully analyze each
security. In the extreme case, a "fully diversified" investor may know or care very little about the
securities he or she holds.

Q-19 If investors are well diversified (e.g., own several hundred stocks), will they have a
greater or lesser need for accounting information? What does this say about
diversification?
As indicated above, an investor who holds many securities does not have the time or resources to
meaningfully analyze them. In this case, the investor is not able to effectively use the accounting
information that is available. Hence, in effect, excessive diversification can lead an investor to be
ignorant of his or her individual investments.
Q-20 What are some limitations of capital market research?
The study of price movements and the pricing mechanism in any market is an imposing task.
Determining cause and effect between information and security prices is especially difficult
because new information is continuously arriving. Since the set of information affecting security
prices is large, it is difficult to isolate the effects of one piece of information. Furthermore, we
are examining only a relatively small group of investors, those at the margin who influence stock
prices. This difficulty means that the tests are going to be somewhat crude rather than precise.
Failure to find evidence of information content should be interpreted cautiously, for the
methodology may is not always capable of detecting information content. For this reason, the
stronger evidence from efficient-markets research exists when there is information content rather
than where there is none.
Another weakness of capital market research is that it is a joint test of both market efficiency and
the model used to estimate the abnormal returns. The absence of price responses is usually
interpreted to mean that the information tested has no information content. This interpretation is
correct only if the market is efficient and if the model used is correct.
Finally market-based research considers only the aggregate effect of individual investor decision
making. That is, the role of accounting information vis-à-vis an individual investor’s decision
making is implicitly modeled as a black box; an “event,” occurs and the effect of this event is
then inferred from whether or not there was an aggregate (market) reaction.
Q-21 What is an event study?
An event study is an empirical research method used in accounting and finance studies to detect
the market’s reaction to some event that should have an impact on the stock price.
Q-22 What are abnormal returns (AR) and cumulative abnormal returns (CARs)? What do
they have to do with research in accounting? What do they have to do with accounting
standards?
An event study divides the period related to the event into three “windows:” an estimation
window, the event window, and the post-event window. The “normal” relationship between a

security’s returns and those of the market is estimated during the estimation window. This allows
the researcher to estimate the parameters for the linear regression equation.
After the parameters have been estimated, the regression equation is used to estimate the returns
at the time of and subsequent to the event. The difference between the actual return and the
return expected using the regression equation is called an abnormal return (AR). The sum of the
ARs is known as the cumulative abnormal returns (CAR). In the absence of an event, the ARs
should randomly fluctuate around zero and the CARs should show no upward or downward
trend.
If an unexpected event has occurred, the AR and the CAR should depart significantly from zero
on the date of the event. However, if the market fully and immediately reflects the new
information in the stock price, the subsequent ARs should again randomly fluctuate around zero,
and the CARs should show no trend.
Event studies are a tool to allow researchers to examine the relationship between the security
prices and the information contained in the firm’s financial statements and associated
documentation. This body of research is important to standard setters. The ability of markets to
efficiently allocate resources (allocational efficiency) is crucially dependant on accounting
information for analysis, valuation, and performance measurement. Investors need to know if the
analysis of accounting data is a value-enhancing activity. Furthermore, standard setters need to
know if the existing standards are fulfilling their intended purpose to improve the informational
and allocational efficiency of markets. If not, it might be time for a new standard.
Q-23 Explain Lee’s (2001) view of market efficiency.
The null hypothesis for much of the capital markets research in accounting has been that the
market fully and instantaneously adjusts to new information; the market price is equal to the
security’s intrinsic value. This instantaneous response of the market is an extreme view. Lee
offers an intriguing alternative in which the price convergence toward intrinsic value value is
characterized as a process, which requires time and effort, and is only achieved at substantial
cost to society.
Q-24 Lee (2001) rejects the “naive view” of market efficiency. Explain. If Lee is correct,
what are the implications for capital markets research in accounting?
Lee suggests that we have been asking the wrong questions. Instead of focusing on or assuming
that the market responds instantaneously to new information, he suggests that we consider
fundamental value and market prices as two distinct measures. Furthermore, instead of assuming
or testing market efficiency, researchers should be studying why, when, and how prices converge
to intrinsic value, and how current market prices might be improved.

Q-25 For event studies, the post event window is typically short (days or months). What are
some issues associated with examining longer event windows (e.g., years)?
For all practical purposes, event tests assume that aside from the event tested, all other things
remain the same (ceteris paribus). However, the longer the post-event window, the lower the
likelihood that ceteris paribus does not hold. If it does not, it becomes more difficult to draw
meaningful conclusions from the data.
Q-26 What do we mean when we say that capital market research involves a joint test of
both market efficiency and the model used to estimate abnormal returns?
In order to test the markets response to new information, the researcher must have a model of
expected security returns. If the market does not appear to be efficient with respect to a piece of
information, several possibilities may exist. The market might not be efficient with respect to the
information analyzed. However, it is also possible that the model used to generate the expected
returns might be flawed, providing for a flawed test. Unfortunately, it is impossible to separate
the two.
Q-27 Describe the general findings from capital market research concerning the information
content of accounting numbers and the effects of alternative accounting policies.
Accounting income numbers have evidenced information content in a wide variety of tests. It
must be emphasized, though, that stock prices are probably affected as much or more by
nonaccounting data. The research on alternative policies is ambiguous. Recent studies have used
agency theory arguments to evaluate differences that, on the surface, appear to have noncash
implications. However, indirect consequences on owner wealth are offered to explain the stock
price responses.
Q-28 Why is the choice between the FIFO-LIFO inventory methods an interesting issue in
capital market research?
The early capital market studies were motivated by tests of whether or not investors were
“fooled” by bookkeeping differences that had no direct cash flow effects on firms. This is an
important issue with respect to how sophisticated we assume users are—it will also affect the
style and substance of accounting reports. For example, the FASB presumes that users are
sophisticated. For the most part, the research rejects the naive investor hypothesis, though there
are troubling anomalies such as the FIFO-LIFO research, which tends to support the notion that
investors react naively to reported earnings without considering how those numbers have been
constructed in terms of alternative (arbitrary) accounting policies.

Q-29 As an investor, how would you react to a company changing is inventory accounting
from FIFO to LIFO? Why?
It would depend on the level of analysis. Change inventory accounting from FIFO to LIFO would
ordinarily result in higher cost of goods sold and lower accounting income. However, because the
same inventory accounting method must be used for both financial reporting and income tax
purposes, taxable income will be lower as well. If the firm pays income taxes, the firm's income
tax bill should decline, and after-tax cash flow should rise. This would be good for shareholders.
Q-30 Over the years, the research findings regarding changing from FIFO to LIFO have
varied? Why do you suppose this is the case?
This issue, along with oil and gas accounting continues to produce some of the most anomalous
results in capital market research. As with the oil and gas issue, the technical aspects of the
research designs have varied across studies, as have the results. The research in this area
highlights the problem of using capital market studies to study subtle issues of accounting policy
choice (as opposed to more general questions such as the information content of reported
earnings).
Q-31 Why may accounting policies with no direct cash flow consequences indirectly affect
investors or creditors?
The argument derives from the agency or contracting theory. Existing contracts can be
affectedby changes in accounting methods that affect accounting numbers used in the contracts.
Typical uses of accounting numbers for contracting are in the areas dealing with restricting
dividends, restricting new debt issues, and providing incentive compensation contracts with
managers.
Q-32 Why is it argued that capital market research cannot determine the optimality of
accounting policies even for the limited investor-creditor group?
Because of externalities associated with financial reporting (free-riders), a market mechanism

does not operate to determine the optimal production of information.
Q-33 How do market-level and individual decision-maker analyses complement one another
in studying the usefulness of accounting information to investors and creditors?
Market-level studies (i.e., capital market research) treat the individual decision maker as a “black
box,” whereas the decision-maker studies focus explicitly on how decision makers respond to
specific information cues in simulated laboratory decision making.

Q-34 Lev talks about the low correlation between earnings and stock returns. Ou and
Penman paper discuss the possibility of making abnormal returns based upon
published financial data. Are these papers in conflict with each other or
complementary to each other?
The papers complement each other. Since Ou and Penman see a predictive role for accounting in
a market that may not be efficient, then Lev’s call for improved accounting measures certainly
makes sense. Furthermore, even if the market were highly efficient, Lev’s call for improved
accounting standards can be interpreted as being concerned with the quality of the signal picked
up by the market, which should result in the market providing a more meaningful equating of
risk and return for individual securities. Wyatt (1983) essentially makes this point.
Q-35 What is post-earnings announcement drift (PEAD)?
If markets are efficient, security prices respond instantly and fully to new, relevant information.
Post-earnings-announcement drift refers to situations in which it takes a much longer period of
time for the market to adjust to unexpected earnings announcements. In some cases, it takes up to
60 days for the full effect of unexpected earnings announcements to be impounded in security
prices.
Q-36 Why does post-earnings-announcement drift challenge the efficient-markets

hypothesis?
Post-earnings-announcement drift is a contradiction of the efficient-markets hypothesis. The

problem lies with the slow length of time it takes for new information to be impounded in
security prices.
Q-37 Why does post-earnings announcement drift appear to be more pronounced with
smaller firms? What could be done from a company perspective to rectify this
situation? What could be done from a standard setting perspective to mitigate the
effects of PEAD?
Post-earnings-announcement drift appears to be more pronounced for smaller firms. There is

evidence that financial analysts underreact to very fundamental signals stemming from securities,
which in turn, lead to forecast errors and incomplete security price adjustments. There is also
evidence that shareholders do not distinguish well between cash flow portions of earnings and
the accrual segment thereof. Another possibility is that in some cases, transaction costs are too
high relative to the potential gain that can be earned from the mispricing of the securities.
Finally, post-earnings-announcement drift appears to be inversely related to the number of
experience analysts following the stock. With smaller firms, there are fewer analysts following
the stock. Indeed, some small firms have no analysts following them.
Smaller firms might be able to mitigate the problem by providing more disclosure and discussion
of cash flows and other analyses normally provided by analysts.

Accounting standards that improve the quality of financial reporting might eliminate some or all
of the post-earnings-announcement drift, providing for better valuation of securities and
ultimately, better allocation of resources in the economy.
Q-38 What is the incomplete revelation hypothesis?
The incomplete revelation hypothesis is a hypothesis that may help to show why markets are less
efficient than we have previously believed. One reason is that it may be more difficult to
determine the effect of some numbers, particularly if they are buried in footnotes. Hence, stock
option disclosures in the footnotes (SFAS No. 123) may be more difficult to assess than if they
were in the body of the income statement. Also, the presence of noise traders may impact upon
market efficiency. These individuals have their own purposes which may not bear directly upon
assessing risk and return. For example they may simply be rebalancing their portfolios,
attempting to attain more liquidity or simply be acting upon whims or irrational tips.
Q-39 Suppose an accounting event occurs and there is no market reaction. What should we
conclude?
It is sometimes hard to say. It could be that information was made available earlier via
nonaccounting means. An example might be industry information revealed by a competitor. It is
also possible that another piece of news has the exact opposite effect as the accounting event. For
example, a firm may have a very positive earnings announcement on the same day that the
Federal Reserve announces that it will increase interest rates.
Q-40 Give some examples in which accounting information is not the most timely source of
information affecting security prices.
There are many examples. In this space we offer only a few. A competitor might announce that
the industry is in a slump. This is apt to affect all firms in the industry. A supplier might
announce that its employees are on strike. This could jeopardize future inputs to a firm.
Commodity prices might increase or decrease for a variety of reasons, and have an immediate
affect on transportation companies.
Q-41 Instead of employing capital markets research techniques (e.g., event studies) why
don’t we just ask investors how they would react to a hypothetical event? Why don’t
we ask managers why they make specific accounting changes?
This is an age-old question. Will the investors and managers provide a truthful answer? If they
provide a truthful answer, will they provide an objective answer? Will their hypothetical answer
be the same as their actual reaction? Finally, it is difficult to survey enough investors and
managers in a timely fashion. In financial markets, we see the effects of decisions in real time.

Q-42 Why is it important to improve the quality of accounting standards?
Accounting information is useful in making valuation and compensation decisions. These

decisions affect securities pricing and ultimately, the efficient allocation of capital in the
economy (allocational efficiency). Directly or indirectly, everyone has a vested interest in the
correct understanding of the financial wellbeing of firms. Since accounting standards have a
substantial affect on the type and quality of accounting information provided, we would argue
that accounting standards have an affect on the efficient allocation of capital in the economy.
With better standards, we would expect improved allocational efficiency.
Q-43 What do pensions have to do with a company’s operating performance? What do

pensions have to do with the firm’s financing and investment decisions?
Operating performance and the ability to generate cash eventually affects the firm's financing
and investment decisions. Poor operating performance might lead to increased financing needs or
to a reduction in investment expenditures. The converse is true for good operating performance.
It is possible that poor operating performance and sub-optimal investment decisions leads to
pension underfunding. On the other hand, it is also possible that poor management of the pension
fund in the form of severe underfunding or poor investment decisions, eventually leads to poor
operating performance and sub-optimal investment decisions.
It appears that investors frequently do not fully recognize that the severe underfunding
hasnegative valuation effects. Why this happens is yet to be resolved. Even when investors
recognize the severe underfunding, it is possible that they may not adequately factor in the
implications of that underfunding, such as difficulty in refinancing at favorable terms or or the
inability to refinance at all.
Q-44 There is evidence that investors do not fully recognize the valuation effects of severe
pension underfunding. (See for example Franzoni, Francesco and José M. Marín
(2006). Why do you suppose this is the case? What changes could be made to mitigate
this problem?
Franzoni and Marín present evidence that the market significantly overvalues firms with severely
underfunded defined benefit pension plans. Furthermore, the effects of the overvaluation persists
for a long time. Perhaps investors do not analyze the information contained in the footnotes as it
relates to pension funding. It is also possible that even when they examine the footnotes, some
investors might not understand the information provided. Finally, it is necessary for investors to
recognize the implications from the information provided.
For example, a pension liability is a debt—a promise to pay—similar to a bond. Firms that have
severe underfunding might find it difficult to refinance existing debt at favorable terms. Worse
yet, it is possible that such firms may not be able to refinance existing debt at all. These kinds of

constraints may affect a firm's ability to undertake future investments and eventually have a
negative affect on future operating performance.
It is possible that improved disclosure or better accounting standards might help investors to
understand the significance a firm's underfunded pension. Including both pension assets and
pension liabilities on the balance sheet might also be useful.
Q-45 Why are accounting ratios valuable for predicting bankruptcy? What cautions do we
need in evaluating accounting ratios?
Accounting-based ratios have been very useful in discriminating between firms that subsequently
went bankrupt and those that did not. Prior to bankruptcy, companies that eventually go bankrupt
tend to have financial ratios that differ from companies that do not go bankrupt. Predictability up
to five years prior to bankruptcy has been demonstrated. Firms are complex enterprises, and it is
not easy to reverse a positive or negative trend.
Note, however, that we must be very careful in drawing conclusions. Companies with “poor”
ratios will not necessarily go bankrupt in the future. However, unless a company's operating or
financial performance changes, bankruptcy is more probable for companies with poor financial
ratios.
Q-46 Accounting earnings are useful in predicting one-year ahead cash flows. Is this
sufficient? Why or why not?
From a financial economic perspective, the value of a firm is equal to the present value all
expected future cash flows. Clearly, the value of the firm depends on much more than the
oneyear-ahead cash flow. Nevertheless, the one-year-ahead cash flow might be indicative of
subsequent cash flows.
Q-47 Why do high levels of accruals appear to be mispriced?
Richardson, Sloan, Soliman, and Tuna find empirical evidence that suggests that accruals are
related to earnings persistence. In addition, the less reliable the accruals, the lower the earnings
persistence. Furthermore, they find that the market does not fully price the less reliable accruals.
Future stock returns appear to be negatively related to accruals, and the negative relation is
stronger for less reliable accruals. Liu and Qi provide evidence that the potential mispricing of
accruals is substantial.
Q-48 Evaluate Stewart’s (2009) discovery of a single overarching ratio, EVA Momentum,
which is “superior to all other ratios.”
Stewart III, G. Bennett (Spring 2009). “EVA Momentum: The One Ratio That Tells the Whole
Story,” Journal of Applied Corporate Finance, 74–84.

Stewart has done another outstanding job of marketing the next financial discovery; however, as
was the case with EVA, we doubt the statement will weather academic empirical research
studies. There is no panacea, no single metric to tell the whole story. However, the idea will
likely enhance consulting revenues.
Cases, Problems, and Writing Assignments

1. The usefulness of accounting data to investors and creditors for predictive purposes is
necessarily forward looking. However, under generally accepted accounting principles,
financial statements are constructed primarily as an historical record.
Required:
(a) What limitation does this impose on the usefulness of financial statements for
predictive purposes, and how is this limitation evident from the research reviewed in
the chapter?
(b) Provide examples of important forward-looking events that either are not reported
in financial statements or are not reported in a timely manner.
(c) Why may the feedback value of audited financial statements make them very
important to investors and creditors even though predictive value is not necessarily
high?
(a)
The FASB conceives of accounting as an information system with the emphasis mainly on
prospective cash flows. Since accounting systems are, by construction, historical records, they
are necessarily backward looking. Therefore, feedback value is going to be better achieved than
predictive value. Consistent with this is the low explanatory power of some capital market
research. Unexpected earnings “explain” only about 5 percent or less of a firm’s abnormal stock
return around the time of earning’s announcements. The capital market literature presumes that
accounting functions as an information system, but it is more likely that its main role is for
contracting and hence feedback purposes.
(b)
A good example is the mutually unperformed (executory) contract in which the firm and an
outside party have an unperformed contract. By convention, such contracts do not meet the
criteria for recognition.
(c)
If accounting is primarily a feedback system, it is nevertheless useful precisely for this reason.
From a contracting perspective, accounting is important in bringing about control and
accountability to investors and creditors, and it is for this reason that accounting numbers are
used in writing contracts. For example, debt contracts with restrictive covenants, and
employment contracts with managers, especially incentive compensation agreements, also
feedback and accountability. They are also helpful to users in predicting cash flows.

A retail company begins operations late in 2000 by purchasing $600,000 of

2.
merchandise. There are no sales in 2000. During 2001 additional merchandise of
$3,000,000 is purchased. Operating expenses (excluding management bonuses) are
$400,000, and sales are $6,000,000. The management compensation agreement
provides for incentive bonuses totaling 1 percent of after-tax income (before the
bonuses). Taxes are 25 percent, and accounting and taxable income will be the same.
The company is undecided about the selection of the LIFO or FIFO inventory methods.
For the year ended 2001, ending inventory would be $700,000 and $1,000,000,
respectively, under LIFO and FIFO.
a. How are accounting numbers used to monitor this agency contract between
owner and managers?
b. Evaluate management incentives to choose FIFO versus FIFO?
c. Assuming an efficient capital market, what effect should the alternative policies
have on security prices and shareholder wealth?
d. Why is the management compensation agreement potentially counterproductive
as an agency-monitoring mechanism?
e. Devise an alternative bonus system to avoid the problem in the existing plan.
(a) The bonus is part of the compensation agreement and is limited to financial performance.
(b) See computations that follow.
FIFO LIFO
Sales $6,000,000 $6,000,000
Cost of Sales 2,600,000 2,900,000
Gross Margin 3,400,000 3,100,000
Operating Expenses 400,000 400,000
Operating income 3,000,000 2,700,000
Taxes on operating income (25%) 750,000 675,000
Basis for Bonus 2,250,000 2,025,000
Bonus (1%) $ 22,500 $ 20,250
In terms of the bonus alone, management would choose FIFO over LIFO. However,
after-tax cash flows will be higher under LIFO.
FIFO LIFO
Gross Margin $3,400,000.00 $3,100,000.00
Operating Expenses 400,000.00 400,000.00
Bonus (1%) 22,500.00 20,250.00
Pre-tax Income 2,977,500.00 2,679,750.00
Taxes (25%) 744,375.00 669,937.50
Difference in taxes paid is $74,437.50 in favor of LIFO ($744,375 minus $669,937.50).
(c) LIFO should increase firm value due to higher positive cash flows arising from lower taxes,
compared with FIFO.

(d) The agreement is a poor one because the bonus encourages a personal gain of $2,250 to the
managers for choosing FIFO at a cost of $74,437.50 in higher taxes to the firm. This choice
reduces shareholder wealth.
(e) Some alternative arrangement might include non-allocation bases such as sales or cash flow
operations, or net cash flows (see chapter 13), or nonaccounting-based incentives such as stock
option plans. Another alternative might be a bonus plan based on LIFO, with management’s
bonus percentage being slightly higher than it presently is to allow for the lower income under
LIFO.
Critical Thinking and Analysis

1. How do you think the efficient-markets hypothesis impacts the drafting of accounting
standards? Bear in mind that many questions have been raised about the efficient-
markets hypothesis itself.
It’s nice that accounting information is presumably rapidly impounded into security prices but
the FASB shouldn’t—and hasn’t—been seduced by the EMH. First of all, the quality of
accounting information can be improved (see Lev, 1989 and Wyatt, 1983). Second, the FASB
should not be indifferent between providing information within the body of the financial
statements themselves and disclosure in footnotes and supplementary information. Third, the
FASB should try and increase publicly available information and reduce inside information. In
short, the EMH should not allow the FASB to slough anything off but should be a spur to
improving financial information.
2. To what extent should the liquidity measures revisions be considered if LIFO were to
be eliminated from U.S. GAAP? Provide examples of those likely measures that would
be affected. . As an interesting side note, what does the 2016 United States Budget
estimate the effect on revenues will be if LIFO accounting for inventory is repealed?
This is a problem somewhat like the one faced when FASB first considered requiring all leases
be placed on the balance sheet. In the case of leases, ratios were affected, severely in some
cases. Inventory days supply on hand, current ratio, debt to asset ratios: they are all affected if a
company values its inventory using LIFO, but then replaces the method with FIFO or weighted
average valuation methods. Gross margins would likely increase on the income statement.
Implementation costs to revise any agreements based on ratios might be costly to specific firms.
The question relates to short-term implementation issues, a cost-benefit issue.
To answer the estimated effect of repealing LIFO, go to

https://www.whitehouse.gov/omb/budget/ and click on “The Budget”. Open the PDF for
“Summary Tables” and FIND “Repeal LIFO method of accounting for inventories.” Note that
the LIFO repeal is listed under “Other business revenue changes and loophole closers” and it
estimates a 2017-2021 deficit reduction of >$38 billion. 2017-2026 the reduction is >$80 billion

(actually $81,335 millions). Inclusion of such a repeal suggests political support from the
Whitehouse for LIFO’s repeal and, therefore, potential convergence with IASB standards.
Trombetta, et al (2012) discusses how effects analyses might help determine the
2.
usefulness of accounting standards. Which research method do you argue provides the
best analysis of a new standard?
Trombetta, Marco, Alfred Wagenhofer, and Peter Wysocki (2012). “The Usefulness of
Academic Research in Understanding the Effects of Accounting Standards,” Accounting in
Europe, 127-146.
Discussions should consider two macro approaches:

• Theoretical approaches: economic, behavioral, historical research, and theorizing.
• Empirical approaches: case studies and field studies, interviews and questionnaire
surveys, archival, and experimental research.
Students should consider who the target users are: investors and creditors. What is the
standard’s purpose: decision usefulness. So, arguments should address how the chosen
method(s) determine how the standard affects decision usefulness. There is not a single correct
answer, but the question should force students to think.

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Chapter 8: Usefulness of Accounting Information Instructor Manual

ACCOUNTING THEORY CONCEPTUAL

Full download link at:

Test bank: https://testbankpack.com/p/test-bank-for-accounting-theory-

Solution Manual: https://testbankpack.com/p/solution-manual-for-

Accounting Theory (9th edition) Page 2 of 18

Accounting Theory (9th edition) Page 3 of 18

Q-4 Who are creditors?

Q-6 What is residual income? Abnormal earnings? Economic profit? EVA?

Q-7 How does EVA differ from economic profit?

Accounting Theory (9th edition) Page 4 of 18

Accounting Theory (9th edition) Page 5 of 18

Q-14 What is the efficient-markets hypothesis?

Accounting Theory (9th edition) Page 6 of 18

Q-16 Why is the efficient-market hypothesis being challenged?

Accounting Theory (9th edition) Page 7 of 18

Q-20 What are some limitations of capital market research?

Q-21 What is an event study?

Accounting Theory (9th edition) Page 8 of 18

Q-23 Explain Lee’s (2001) view of market efficiency.

Accounting Theory (9th edition) Page 9 of 18

Accounting Theory (9th edition) Page 10 of 18

Because of externalities associated with financial reporting (free-riders), a market mechanism

Accounting Theory (9th edition) Page 11 of 18

Q-35 What is post-earnings announcement drift (PEAD)?

Q-36 Why does post-earnings-announcement drift challenge the efficient-markets

Post-earnings-announcement drift is a contradiction of the efficient-markets hypothesis. The

Post-earnings-announcement drift appears to be more pronounced for smaller firms. There is

Accounting Theory (9th edition) Page 12 of 18

Q-38 What is the incomplete revelation hypothesis?

Accounting Theory (9th edition) Page 13 of 18

Q-42 Why is it important to improve the quality of accounting standards?

Accounting information is useful in making valuation and compensation decisions. These

Q-43 What do pensions have to do with a company’s operating performance? What do

Accounting Theory (9th edition) Page 14 of 18

Q-47 Why do high levels of accruals appear to be mispriced?

Accounting Theory (9th edition) Page 15 of 18

Cases, Problems, and Writing Assignments

Accounting Theory (9th edition) Page 16 of 18

A retail company begins operations late in 2000 by purchasing $600,000 of

Difference in taxes paid is $74,437.50 in favor of LIFO ($744,375 minus $669,937.50).

Accounting Theory (9th edition) Page 17 of 18

Critical Thinking and Analysis

To answer the estimated effect of repealing LIFO, go to

Accounting Theory (9th edition) Page 18 of 18

Discussions should consider two macro approaches:

Accounting Theory (9th edition) Page 19 of 18

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