ac3103 seminar 2 answers

7/23/2019 AC3103 Seminar 2 Answers

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AC3103: SEMINAR 2

2-10. Explain why, under non-ideal ondi!ion", i! i" nee""ary !o !rade

o# rele$ane and relia%ili!y when e"!i&a!in' (u!ure a"h )ow". *e+ne

rele$ane and relia%ili!y a" par! o( your an"wer.

Relevant information is dened as information that enables investors to predictthe rm’s future cash ow. Reliable information is information that faithfully

represents without bias what it is intended to represent and is precise.

Where conditions are not ideal, the estimation of the PV of the future rm’s cash

ow (i.e. relevant information re!uire specication of a set of possible future

cash ow amounts (i.e. state of nature. "he probabilities of the state of nature

are sub#ective and based on estimation. $uch estimation are sub#ect to errors

and possible bias, reducin% reliability.

&onversely, reliable information such as the historical cost of a capital asset or

face value of debt, tends to be low in relevance because this basis of valuation

involves no direct estimates of future receipts or payments. 'istorical

information !uicly lose relevance since maret value, e)pected future receipts

and interest rates chan%e over time. "herefore, relevance and reliability

characteristics of accountin% information must be traded o*, since an increase in

one leads to a decrease in the other.

2-2. A !heore!ially orre! &ea"ure o( ino&e doe" no! exi"! in !he

real world in whih aoun!an!" &u"! opera!e.

Re/uired:

a. ha! i" &ean! %y !he phra"e a !heore!ially orre! &ea"ure o(

ino&e

+ theoretically correct measure of income is the net income of a rm for a

period calculated on a present value basis that is, accretion of discount on

openin% rm present value, plus or minus any di*erences between

e)pected and actual cash ows for the period. +lternatively, net income is

theoretically correct if it is calculated so as to include the chan%es durin%

the period in the maret values of all assets and liabilities, ad#usted for

capital transactions (providin% that the marets for all assets and liabilities

e)ist and wor reasonably well.

%. hy doe" a !heore!ially orre! &ea"ure o( ino&e no! exi"! in!he real world

+ theoretically correct measure of income does not e)ist because ideal

conditions do not e)ist. +s a result, future cash inows and outows from

assets and liabilities cannot be reliably estimated. "his means that present

value-based net income is not theoretically correct since theoretical

correctness re!uires complete reliability. urthermore, maret

incompleteness can e)ist in the absence of ideal conditions. "hen,

properly worin% maret values for all assets and liabilities of a rm need

not e)ist. +s a result, net income based on net chan%es in maret values is

not theoretically correct either.



. u!line !he !radeo#" %e!ween rele$ane and relia%ili!y under

hi"!orial o"! aoun!in' and urren! $alue aoun!in'. Con"ider

%o!h "i!ua!ion" where rea"ona%ly well-worin' &are! $alue"

exi"!.

'istorical cost accountin% is reasonably reliable because the cost of anasset is usually an ob#ective and veriable number. 'owever, while cost is

also relevant at time of ac!uisition, it may lose relevance over time due to

chan%es in maret prices, interest rates and economic conditions, which

will chan%e the asset’s current value. "o the e)tent reasonably-worin%

maret prices e)ist, current value accountin% is more relevant than

historical cost while retainin% reliability. 'owever, if such maret values do

not e)ist, current valuation re!uires estimates of fair value, cash ow

estimates, or the use of models. /stimates of cash ows face serious

problems of reliability, as do the inputs into valuation models.

3-4. In Se!ion 3.5.1, !he !ex! re(er" !o !he "!udy o( 6i& and Cro"", who

repor!ed !ha! !he a%ili!y o( urren! earnin'" !o predi! nex! period7"

opera!in' a"h )ow" exeed" !he a%ili!y o( urren! opera!in' a"h )ow"

!o predi! nex! period7" opera!in' a"h )ow". 8i$e an explana!ion (or

!hi" re"ul!.

"he ar%ument is probably made because of the lumpiness of certain cash

receipts and disbursements. &ash payments for ma#or purchases such as capital

assets, and for borrowin%s such as loan proceeds, tend to occur at discrete

intervals in lar%e amounts. +s a result, a rm could have what appears as a

favourable cash ow, but one which results, for e)ample, from the proceeds of a

lar%e borrowin% rather than from recurrin% operatin% transactions. $ince nancial

statement users are primarily interested in the rm’s ability to %enerate cashfrom operations, it would be necessary to separate out the e*ects on cash ows

of ma#or transactions such as these.

/ven within the cate%ory of operatin% cash ows, there can be lumpiness of

receipts and payments -- for e)ample, a lar%e collection on account may come in

shortly after year end. 0nder a strict cash basis, this would not appear as a cash

ow in the year. 0nder accrual accountin%, of course, the account receivable (an

accrual and revenue from such a transaction would be included in the nancial

statements re%ardless of whether the cash was collected yet or not.

1n e*ect, the +$2 seems to be ar%uin% that accrual accountin% enables a better

prediction of avera%e or lon%er-run future operatin% cash ows or, more

%enerally, of future rm performance, by recordin% the inows (revenues and

outows (e)penses in the period in which the ma#or economic activity relatin% to

those ows taes place. "his seems reasonable since accruals anticipate

operatin% cash inows or outows. "he recordin% of accruals results in a more

timely reco%nition of these cash ows.

9-1. wo +r&", o( !he "a&e "i;e and ri", relea"e !heir annual repor!"

on !he "a&e day. I! !urn" ou! !ha! !hey eah repor! !he "a&e a&oun! o(

ne! ino&e. <ollowin' !he relea"e, !he "hare prie o( one +r& ro"e

"!ron'ly while !he o!her ro"e hardly a! all. Explain how i! i" po""i%le (or

!he &are! !o rea! po"i!i$ely !o one +r&7" annual repor! and hardly a!



all !o !he o!her when !he +r&" are "i&ilar in "i;e, ri" and repor!ed

pro+!a%ili!y.

"he di*erin% maret response could be e)plained by a di*erence in the maret’s

e)pectations of earnin%s. "he net income of the rm that had the stron% reaction

may have been hi%her than e)pectations, whereas the net income of the other

rm may have been e!ual to or less than e)pectations. +nother reason could be

a di*erence in the !uality of earnin%s. "he rms may have used di*erent

accountin% policies. or e)ample, one rm may have used declinin%-balance

amorti3ation and successful-e*orts accountin%, whereas the other may have

used strai%ht-line and full-cost methods. 1f the accountin% policies of one rm are

more relevant and4or reliable than those of the other, the main dia%onal

probabilities of its information system would be hi%her, inducin% a stron%er

maret response. inally, the informativeness of price could have di*ered

between the two rms, althou%h this is less liely when the rms are the same

si3e. 'owever, the rm whose share price chan%ed only sli%htly may have

released more information durin% the year, say by !uarterly reports, forecasts, ormana%er speeches, and the e5cient maret would build this information into the

share price prior to the earnin%s announcement.

9-4. n =anuary 21, 13, he all S!ree! =ournal repor!ed !ha! 8eneral

Ele!ri Co7" (our!h /uar!er 12 earnin'" ro"e >.2? !o @1.39 %illion or

@1.45 a "hare, "e!!in' a new reord and %rin'in' !he earnin'" (or 12

!o @9.53%illion or @4.41 a "hare. A(!er adu"!in' (or low per"i"!ene

i!e&", 12 earnin'" (ro& on!inuin' opera!ion" were up a%ou! 10?

(ro& !he pre$iou" year.

he =ournal al"o repor!ed !ha! (orea"! &ade %y analy"!" a$era'ed

@1.>1 per "hare (or !he 9!h

/uar!er o( 12 and (ro& @4.40 !o @4.>0 per"hare (or !he whole year. ne analy"! wa" /uo!ed a" "ayin' !ha! 12

wa"n7! a %ad year (or 8E de"pi!e !he down!urn in !he "!o &are! on

!he day o( !he earnin'" &ana'e&en!.

Be!, on !he "a&e day !he (our!h-/uar!er earnin'" were announed,

8eneral Ele!ri Co7" "hare prie (ell on !he NBSE.

Re/uired:

a. 8i$e 3 rea"on" !o explain why !hi" ould happen

6ne reason is that 7889 fourth !uarter earnin%s came in lower thane)pected by analysts and the maret, and, for the whole year, earnin%s

were near the lower end of analysts’ forecasts. $ince e)pected 7889

earnin%s would already be built into the rm’s share price by the e5cient

maret, actual earnin%s lower than e)pectations would cause the share

price to fall, as investors revised downwards their beliefs about future rm

performance.+ second reason is that :/’s earnin%s !uality may have chan%ed. Perhaps

:/ switched to less relevant and4or reliable accountin% policies durin%

7889. 1f the e5cient maret did not now this until the 7889 earnin%s were

released, it would then as ;why the chan%e in accountin% policies to

lower earnin%s !uality<= "his could tri%%er a decline in share price at thattime.



+ third reason is the possibility of noise traders. "here may have been a

lar%e increase in the supply of :/ shares comin% to the maret due to

random factors.

%. "e !he Sharpe-Din!ner CAM !o explain how !he new in(or&a!ion

au"ed !he urren! prie !o all. Calula!ion" are no! re/uired.

"he new earnin%s information apparently lowered investors’ prior

e)pectations of :/’s future protability and dividends. 1n terms of

e!uation (>.9, the maret’s e)pectation of P#t ? @#t fell. $ince, from

e!uation (>.A, /(R#t is determined by Rf, B# and /(RCt, none of which is

directly a*ected by the new earnin%s information, the current price P#,t-7

in the denominator of e!uation (>.9 (here, t-7 is Danuary 97, 788A must

fall to restore the e!uality of this e!uation.

9-11. A &aor rea"on (or !he rari!y o( (or&al +nanial (orea"!" in

annual repor!" i" !he po""i%ili!y o( law"ui!" i( !he (orea"! i" no! &e!,par!iularly in !he S. n No$ 15 14, he S= repor!ed !ha! !he SEC

wa" "uppor!in' a %ill %e(ore !he .S Sena!e !o pro$ide pro!e!ion (ro&

le'al lia%ili!y re"ul!in' (ro& (orea"!", pro$idin' !ha! &eanin'(ul

au!ionary "!a!e&en!" ao&pli"hed (ro& (orea"!.

Re/uired:

a. I( +r&" are di"oura'ed (ro& pro$idin' +nanial (orea"!" %y !he

pro"pe!" o( li!i'a!ion, how ould !hi" lead !o a ne'a!i$e i&pa!

on !he worin' o( "euri!ie" &are!" Can you 'i$e an ar'u&en!

!ha! a li!i'iou" en$iron&en! &i'h! a!ually i&pro$e !he worin'

o( "euri!ie" &are!"ailure to forecast can have a ne%ative impact on the worin% of securities

marets because share prices are then less able to incorporate

mana%ement’s plans and e)pectations about future rm performance. +s

a result, rms with e)cellent future prospects may be undervalued and

rms with poor prospects overvalued, relative to fundamental value.

&onse!uently, the capital maret is less able to direct scarce investment

capital to its most productive uses. 1f mana%ers face a lower prospect of

le%al liability for poor forecast accuracy, the number of rms issuin%

forecasts would increase, other thin%s e!ual. 'owever, these forecasts

may be biased, less accurate and less credible to investors, sincemana%ers face fewer penalties for poor forecastin%. "he net impact on

the worin% of capital marets would depend on the net e*ect of these

two opposin% factors. 1f the second e*ect dominated, for e)ample, so that

poorer !uality forecastin% overcomes their increased availability, a

liti%ious environment would reduce this e*ect, thereby helpin% capital

marets to wor better.

%. Explain how !he pa""a'e o( a %ill "uh a" !ha! &en!ioned a%o$e

&i'h! %ene+! in$e"!or".

Passa%e of the bill would benet investors if the rst e*ect above

dominates the second. "his would be more liely if ;cautionary

statements= were made, as recommended, since investors would then be



alerted to the possibility of forecast inaccuracy. "his would benet

investors if it alerts them to accept the forecasts ;with a %rain of salt,=

that is, to mae their own evaluation of the plausibility and credibility of

the forecasted information.

. Explain how pa""a'e &i'h! %ene+! +r&".

Passa%e would benet rms if %reater investor condence in the maret as

a ;level playin% eld= resulted from increased incidence of forecastin%.

"his would reduce the maret’s concern about lemons and estimation ris,

thereby increasin% demand for shares and lowerin% rms’ costs of capital.

ac3103 seminar 2 answers

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