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financial accounting theory

Questions and Answers of Financial Accounting Theory

Define the concepts of sensitivity and precision of a performance measure. How can accountants increase sensitivity? Precision? Why do these two desirable qualities have to be traded off?
Suppose in Example 9.3 that net income turns out to be $25, despite the assumption that net income can only be one of $115 and $40. How could this happen, and what does it say about the completeness
U-Haul, a “do-it-yourself” moving company, is doing a booming business these days. The reason is that some companies relocating employees are changing the way they reimburse moving expenses.
The controversy over expensing of ESOs can be analyzed as a non-cooperative game. Let the two players be the large, powerful corporations who wish to prevent expensing, and the standard setter. Each
the shareholders of X Ltd. will vote at the forthcoming annual meeting on a proposal to establish a bonus plan, based on firm performance, for X Ltd. management. Proponents of the plan argue that
The following table depicts a non-cooperative game between an investor in a firm’s shares and the firm's auditor.The investor has two strategies—invest or not invest. The auditor can choose to
Pierre is negotiating with Yvonne as a-possible manager. He wants the manager to work hard, since his past experience is that hard work generates a net income (before any manager compensation) of
Tom operates a small, fast-growing electronics business. His workload has expanded to the point where he decides to hire a full-time manager so that he can concentrate on the technical aspects of the
Henri owns and operates a small successful sporting goods store. He has not had a holiday“for three years. He decides to take an extensive one-year trip around the world and is negotiating with
Mr. K, a risk-neutral investor, is contemplating a one-year 8% loan of $500 to firm J.Mr. K demands at least a 6% expected return per annum on loans like this. K is concerned that the firm may not be
Toni Difelice is contemplating lending $10,000 to Tech Enterprises Ltd. Tech offers her 8%interest with the principal to be repaid at the end of the year. Toni carefully examines the financial
Arnold is the successful owner and operator of a small business. He plans to take a on year vacation and is interviewing Minnie for the position of manager while he is away.On the basis of extensive
Refer to Example 9.4. Show calculations to verify the statement in the example that with a profit share of 0.3185 the manager will work hard and receive reservation utility.Explain why the contract
A problem with many games is that they can have multiple Nash equilibria. This makes it difficult to predict the outcome of the game.As an illustration of a non-cooperative game with multiple
The owner of a medium- size electronics company is concerned about cash flow. The company operates in a growing industry and produces a product that is in high demand. The owner feels that cash flow
You are engaged by the owner of a small firm to recommend a one-year compensation contract for the firm’s top manager. The owner is concerned about cash flow and feels that, in previous years, the
What will be the impact on relevance, reliability, and decision usefulness of financial statement information as accountants adopt the measurement approach?
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 investors are not
An investor considers two mutual funds. Based on past experience, the first fund has expected return of 0.08 and standard deviation of 0.05. The second fund has expected return of 0.07 and standard
Ley, in his article “On the Usefulness of Earnings” (1989), points out the low ability of reported net income to explain variations in security prices around the date of release of earnings
In Section 6.4, the concept of value relevance of net income is introduced. It appears that the value relevance of reported earnings, as measured by R2 or ERC, is low, and falling over time. Use
For what reasons might transactions costs, including investors’ time to figure out and operate strategies that appear to beat the market, not be a completely adequate explanation for the efficient
Define two barriers to arbitrage, and explain why these might explain the continued existence of efficient securities market anomalies such as post-announcement drift and the accruals anomaly.
Reproduced below is the Economic Value Added (EVA) disclosure from the MD&A section of the 1996 annual report of Domtar, Inc. Some of the uses of EVA are outlined in Domtar’s discussion in the
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
Recent years have seen considerable litigation against auditors in the United States. A major source of this litigation arises from the pressure firms feel to meet analysts’ earnings expectations.
In its 2005 annual report, TD Bank Financial Group (TD) reports economic profit of $1,062 million. Its calculation of economic profit is summarized as follows (millions of dollars):Requireda. What is
Philip Services Corp. was a large Canadian company with shares traded in Canada and the United States. Its extensive operations included recovery and recycling of scrap metals. In 1997, the company
Accounts receivable are usually valued on the balance sheet at current value, namely the amount owing from customers less an allowance for uncollectible accounts. Does this violate the historical
A firm receives cash this period as payment for services to be rendered next period. The firm records the amount of cash received as a deferred liability on its balance sheet, to be transferred to
Explain why a firm may not necessarily reduce its price risks to zero by means of hedging transactions.
On August 31, 1999, an article in The Globe and Mail, "2000: New year, new accounting, new costs,” anticipated the introduction of Section 3461 of the CICA Handbook, requiring accrual accounting
Refer to the El Paso Corporation vignette (Theory in Practice 7.2) in Section 7.3.5.Requireda. As a U.S. corporation, El Paso is subject to U.S. GAAP. Why are unrealized gains and losses on
Under IAS 39 and SFAS 115, most loan assets held by banks are held in the loans and receivables or held-to-maturity categories, where they are valued at amortized cost. Of course, if the fair value
On March 11, 2000, The Globe and Mail reported “Ballard losses double.” The reference was to Ballard Power Systems Inc., a Canadian developer of fuel cell technology. On March 10, 2000, Ballard
As mentioned in Theory and Practice 7.3, JDS Uniphase Corporation reported a preliminary loss of $50.558 billion for the year ended June 30, 2001. In a July 26, 2001, news release accompanying its
Refer to the sensitivity analysis of Suncor Energy Inc. reproduced in Table 7.2. The analysis discloses the potential effects of changes in prices and production of oil and natural gas, and of
EnCana Corp. a large Canadian oil and gas company, reported net income of $393 million U.S. (EnCana reports in U.S. dollars) for its third quarter, 2004. This compares with net income of $290 million
In a press release dated April 23, 2005, Canadian Natural Resources Limited (CNRL)reported a loss of $679 million from cash flow hedges of its crude oil and natural gas production, for the quarter
Refer to Theory in Practice 7.1, describing how The Blackstone Group proposed to account for the carried interest to be received from future earnings of unconsolidated firms it has invested
A serious problem with fair-valuing complex financial instruments was revealed by the August 2007 meltdown of markets for collateralized debt obligations (CDO) and other asset-backed securities.The
Explain the difference between a normative and a positive theory. Give an example of each.
Can a positive theory make good predictions on average, even though it may not capture exactly the underlying decision processes by which individuals make decisions? Explain.
How is a firm's susceptibility to political costs often measured in positive accounting theory? Do you think this is a good measure? Explain.
In his article "The Impact of Accounting Regulation on the Stock Market: The Case of Oil and Gas Companies," Lev (1979) examined the daily returns on a portfolio of oil and gas companies' common
Use the efficient contracting form of positive accounting theory to explain why managers would prefer to have GAAP allow a set of generally accepted accounting policies from which to choose, rather
Use positive accounting theory to explain how conservative accounting can contribute to efficient contracting.
Standard setters have introduced standards requiring current value accounting for OPEBs(IAS 19, SFAS 106, 158). According to SFAS 106 (paragraph 124), “accrual accounting will more appropriately
The Globe and Mail (November 6, 2002, p. B1), reported “New accounting rules sow confusion about oil earnings.” This refers to changes, effective January 2002, to Section 1650 of the CICA
Following the 1990 Iraqi invasion of Kuwait, the price of crude oil soared, as did retail gasoline prices. This led the major U.S oil companies to try to hold down their reported earnings.the oil
Many companies issue large numbers of stock options to executives and other employees.These companies frequently buy back some of their shares on the open market. For example, Microsoft Corp., which
For large public corporations, SFAS 123R was effective for periods beginning after June 15, 2005. However, the exposure draft of this standard met considerable opposition, mostly from large
On October 25, 2002, The Globe and Mail (p. B2) reported “Former Big Bear head denies manipulation.” The article describes accusations against the former CEO of Big Bear Exploration Ltd. in a
Recent years saw a significant increase in “covenant-lite” debt, under which debt contracts had few if any debt covenants. For example, a private equity firm may issue such debt to finance a
Explain the information approach to financial reporting. Does it rely on the historical cost basis of accounting?
Refer to the separation of market-wide and firm-specific security returns as shown in Figure 5.2. What factors could reduce the accuracy of the estimate of abnormal returns? Figure 5.2 Separating
Explain why the market might begin to anticipate the GN or BN in earnings as much as a year in advance, as Ball and Brown found in Figure 5.3. Abnormal Performance Index Figure 5.3 Abnormal Returns
Give examples of components of net income with:a. High persistenceb. Persistence of 1c. Persistence of 0
Explain why it is desirable to find the exact time that the market first became aware of an item of accounting information if any security price reaction to this information is to be detected. Can
XYZ Ltd. is a large retail company listed on a major stock exchange, and its reported net income for the year ended December 31, 2009, is $5 million. The earnings were announced to the public on
In a classic study, Beaver (1968) examined the trading volume of firms' securities around the time of their earnings announcements. Specifically, he examined 506 annual earnings announcements of 143
Discuss the impact of firm size on the ERC
X Ltd is a growth firm that uses very conservative accounting policies. Y Ltd. is growing more slowly and uses current value accounting for its capital assets and related amortization Otherwise, X
On the basis of the empirical evidence presented in this chapter, do you feel the FASB is correct in its claim in SFAC 1 (see Section 3.8) that investors' expectations about future enterprise
By defining extraordinary items to be infrequent, not typical of normal business activities and not depending on management decision, Section 3480 of the CICA Handbook greatly Increases the need for
It is important to realize that different bases of accounting, such as current value accounting and historical cost-based accounting, do not affect total earnings over the life of the firm, but only
On October 19, 2000, The Globe and Mail reported on Imperial Oil Ltd.'s earnings for the third quarter ended on September 30, 2000, released on October18.Net income was a record $374 million, up from
Refer to Theory in Practice 5.2 in Section 5.5 concerning the September 11 terrorist attacks in the United States..Requireda. Do you agree that the costs resulting from September 11 are not
On October 21, 2004, Abitibi-Consolidated Inc., a large Canadian-based newsprint and groundwood producer, reported income from continuing operations for its third quarter, 2004, of $182 million, or
An article in The Globe and Mail, February 16, 2002, reported that IBM used the $300 million proceeds of a sale of one of its business units to reduce operating expenses in its fourth quarter 2001
What assumptions, if any, does historical cost accounting make about the purchasing power of the currency?
As shown in this chapter, Mautz (1973) made the following statement:Accounting is what it is today not so much because of the desire of accountants as because of the influence of businessmen. If
What are holding gains, and how are holding gains treated if current cost accounting is applied? Do we need to differentiate between realised and unrealised holding gains?
Should ‘profits’ that result from holding gains be allowed to be distributed to shareholders? Explain your view.
Evaluate the statement of Chambers (1995, p. 82) that ‘in the context of judgement of the past and decision making for the future, the products of Current Value
Accounting of the Edwards and Bell variety are irrelevant and misleading. No budget can properly proceed except from an up-to-date statement of the amount of money’s worth available to enter the
Despite the efforts of authors such as Chambers, Edwards and Bell, and Sterling, historical cost accounting has maintained its position of dominance in how we do financial accounting. Why do you
The IASB Framework for the Preparation and Presentation of Financial Statements does not prescribe a specific approach to measurement. However, in recent years accounting standards have been released
Is the notion of ‘prudence’ as described in the IASB Framework consistent with the notion of ‘neutrality’ as also described within the IASB Framework?
The two main qualitative characteristics that financial information should possess have been identified as relevance and reliability. ls one more important than the other, or are they equally
Do you think that the newly proposed definitions of assets and liabilities, as proposed in the joint work being undertaken by the IASB and FASB (and reproduced in this chapter), will have major
The definition of financial statement users provided at paragraph 9 of the IASB Framework encompasses investors, employees, lenders, suppliers, customers, government and their agencies, and the
Within the joint conceptual framework project being undertaken by the IASB and FASB, the following objective of general purpose financial reporting has been proposed (IASB, 2008a, p. 14):The
Read the following quote from the FASB and IASB (2005, p. 5) and evaluate the view that ‘reliability should be the dominant characteristic of financial statement measures’.Some FASB and IASB
The FASB and IASB (2005, p. 12) state:The long-standing unresolved controversy about which measurement attribute to adopt—particularly between historical-price and current-price measures—and the
Explain the efficiency perspective and the opportunistic perspective of Positive
Accounting Theory. Why is one considered to be ex post and the other ex ante?
Would managers who have negotiated debt contracts with accounting-based covenants based around ‘rolling GAAP’ be relatively more likely to lobby an accounting standard-setter about a proposed
Organisations typically have a number of contractual arrangements with debtholders, with many covenants written to incorporate accounting numbers.(a) Why would an organisation agree to enter into
Mather and Peirson (2006) report that public debt contracts tend to have a lower average number of accounting-based debt covenants as well as less binding debt covenants. (For example, in relation to
Read Accounting Headline 7.6. As you will see, Babcock and Brown had negotiated an agreement with lenders that its market capitalisation would not fall below an
If an organisation was involved in a major accident or incident, would you expect it to use vehicles such as an annual report to try to explain the incident? If so, explain how and why it would use
What has the environment to do with accounting?
Do conventional financial accounting practices and definitions encourage or assist corporations to adopt sustainable business practices? Explain your answer.
Why do you think that the accounting profession has generally not released any accounting standards pertaining to the disclosure of environmental information?
How would the following theories (addressed in Chapters 7 and 8) explain corporate social responsibility reporting?(a) Positive Accounting Theory(b) Legitimacy Theory(c) Stakeholder Theory(d)
In publicly released reports a number of organisations are referring to their ‘public licence to operate’. What do you think they mean by this, and is there a theoretical perspective that can
Read Accounting Headline 9.14 and discuss how the BBC will account for the job losses it creates. Do you think it is a limitation of financial accounting that the BBC can show an increase in profits
Read Accounting Headline 9.16 and then answer these questions.(a) How would a brewery company account for the social costs created by alcohol abuse?(b) Should a brewery company account for the social
Would you expect an earnings announcement by one firm within an industry to impact on the share prices of other firms in the industry? Why?

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