Q12-6

(A):
Why might a manager withhold bad news?

★ Cover up evidence of company shrinking, if the bad
news comes from low manager effort
★ Enable insider trading profits
★ Delay fall of share price, which can increase capital cost
and possibly affect manager’s compensation
★ Postpone reputational damage to the firm

(B):
When will the disclosure principle operate to
motivate the manager to report bad news?
★ Information can be ranked from good to bad in terms of its
impact on firm value
★ Investors know that managers have the information
★ No cost for the firm to release the information
★ Market forces and/or penalties in place to ensure the release
of truthful (credible) information
★ Should the information affects variables used for contracting
(can include share price or covenant ratios), releasing the
information do not impose cost increment on the firm

(B): Under what conditions is the disclosure principle subject to failure? ★ Information is proprietary ★ Unsure if the manager has the information ★ Accounting standards (or GAAP) quality is not too high ★ If releasing the information will cause more competitors entering the market. then the firm will disclose some information ★ If contracts are based on share price and releasing the information will increase the firm’s contracting cost .

(B): Accou nting Unsure Infor stand if the mati ards manag on is (or er has prop GAAP) the rieta qualit inform ry y is ation not high ★ N ★ New ★ Inf e s or w will m .

(B): Contracts are based Releasing in share the price and informati releasing on may the news trigger will entry of increase competito firm’s rs contracti Conclusion: ng costs While disclosure ★ principle Firm ★ Not has the in will potential firm’s to motivate .

Q13-4 .

what are the advantages of Employee Stock Options (ESOs) as a compensation device? ★ Alignment with Shareholder Interests ★ No Cash Outlay ★ No Effect on Net Income ★ Longer-Run Decision Horizon ★ Low Downside Risk .(A): In theory.

(A): Alignmen No Cash t with Outlay Sharehold er Interests ★ Value ★ Firms of ESO not depend require ent on d to share pay price cash as .

(A): No Longer Low Effec Run Dow t on Decision nsid Net Horizon e Inco Risk me ★ B ★ EMH. ★ L e Stron o f g w o would e r mean s e that t 2 inves v 0 tors al .

during the period leading up to the 2007-2008 market meltdowns. what were the claimed negative effects of the ESOs on financial institution managers’ incentives and actions? ★ Shortened Manager’s Decision Horizon ★ Opportunistic Manager Behaviour ★ Pressure to Meet Earnings Forecast ★ Excessive Risk Taking .(B): In practice.

Pressuring then sell the shares compensation before share committees price to grant fell back.(B): Shortened Manager’s Decision Horizon ★ Actions taken to increase share price in the SR to maximise personal gains Opportunistic ★ Pump Behaviour Manager and Dump - Increase share value ★ Spring before- Loading exercising options. ESOs unscheduled to maximise shortly before GNcash .

(B): Pressure to Meet Earnings Forecast ★ Value of ESO is dependent on share price. which can be greatly affected if investors’ Excessive Riskearnings Taking expectations are not ★ met ESOs have low ★ downside Managers’ riskmightand resortupside high to rewards extreme measures to ★ Managers inflate stand to reported lose littleearnings from any risk-taking behaviour that is .

(C): Are ESOs an expense? Explain why or why not. ESO is an expense ★ Represents an opportunity cost ○ Forgo opportunity to issue shares at market price ■ Dilute current shareholder s’ value ○ Value can be .

(D): With what theory of regulation are the claims of opponents of the proposed standard most consistent? With what theory are the FASB’s actions in implementing the new standard more Opponents of consistent? Explain your answers proposed standard ★ Aligned with interest group theory ○ Proposed standard results in ESO .

(D): FASB .Aligned with both theories ★ Public interest theory ○ Aim to maximize social welfare ○ Expensing ESO may reduce negative effects of ESO ○ Net profit better represent true performance of firm .

★ Decision Usefulness ★ Reduction of Information Asymmetry ★ Economic Consequences ★ Political Aspects .(E): Suppose that you are a member of the FASB. Evaluate a proposal to expense ESOs in relation to the four criteria suggested in Section 13.5.

(E): Decision usefulness ★ Relevance ○ Improved relevance ■ Higher ESO expenses is an indicator of lower dividend ★ Reliability ○ Reduced reliability ■ Fair value model .

Evaluation for both Information Asymmetry Reduction and .(E): Reduction of information asymmetry ★ Current standard (2004) requires fair value of ESO to be stated in the Notes to FS.

(E): Economic consequences ★ Costly to the firms and managers (Interest Group Theory) ○ Greater probability of violating Debt Covenants ○ Affects Manager’s Future Bonuses. .

(E): Political aspect ★ No agreement on the proposed standard for expensing ESO ★ There are equally powerful proponents and opponents of the new standard ○ Result of the .

Q13-8 .

Case Study: ★ Requirement for listed foreign companies in USA to reconcile their FS from IASB to US GAAP standards cancelled in 2007. ★ SEC is considering to allow US companies to choose between US GAAP and IASB GAAP to prepare their FS. ★ This results in competition between IASB and FASB ★ Possibility of “race to the top” instead of “race .

(A): What is meant by a “race to the top” in this context? ★ It refers to each Standard Setting Body raising the quality of its accounting standards. with the expectation that firms will choose higher quality standards for preparing financial statements .

why might a race to the top.(B): Assuming that Standard Setting Bodies wish to maximise the number of firms using their standards. result? ★ Higher quality information means lower estimation risk for investors. rather than a race to the bottom. Firms that are committed to high quality reporting will urge Standard Setters to raise standards quality. hence it lowers cost of capital ★ Signalling effect. ★ Higher quality reporting improves manager's .

there will be an increase in network externalities due to reduction in comparability of financial statements. Thus. and in the absence of full standards convergence. investors have to become aware of the differences in the standards. investors must also be aware that IASB standards may be applied differently by firms . what difficulties are created for investors who wish to use financial statements for investment decisions? ★ Without reconciliation. ★ Even with convergence.(C): Given the SEC’s dropping of its reconciliation requirement.

Q13-19 .

(A): Assuming that the goal of standard setters is to ultimately value all assets and liabilities at fair value. . is the inclusion of unrealised gains and losses in other comprehensive income most consistent with the public interest or the interest group theory of regulation? Explain.

(A): Public interest vs Interest group theory of regulation Public Interest Theory = Regulators act in the best interest for society Interest Group Theory = Regulators act for the most “powerful” interest group in helping them retain power .

However. 2. goal of standard setters prefer to value all assets and liabilities at fair value. Conclusion : Conflict of interest between both parties . They dislike the volatility that fair value accounting creates and the reduced ability to manage earnings that results from fair value accounting.(A): Background : 1. Banks tend to dislike fair value accounting for financial instruments.

★Inclusion of unrealized gains and losses on available-for-sale financial instruments and fair value hedges in other comprehensive income ★Cost-based accounting for held-to-maturity financial instruments ★Fair value option .(A): Outcome : IAS 39 contained several compromises to reduce management concerns.

Combined firms Part of a choose this latter option. Why? Comprehensi OCI Statement of ve Changes in Income Shareholders’ Statement Equity .S.(B): Under the original 1997 FASB accounting standard (SFAS 130). This latter option shows OCI apart from net income. Most U. OCI could be reported either in a combined comprehensive income statement or as part of a statement of changes in shareholders’ equity.

we need to understand management attitude towards disclosure of unrealised gains and/or losses. firms like to report OCI apart from net income because: 1. ★ Dislike to disclose unrealised gains and losses that are in OCI Therefore.(B): First. Less noticeable when it is “hidden” in the statement of changes of equity . It would be further from the eyes of the investor 2.

★ Under the Efficient Securities Market Theory. .(C): Is inclusion of OCI in a separate statement of changes in shareholders’ equity consistent with managers’ acceptance of efficient securities market theory? Explain. ★ Not consistent. the market will evaluate OCI information regardless of its location in the Financial Statements. all publicly available information will fully reflect the fundamental value of a firm’s share at all times. ★ Hence.