Question 1 (16 marks) Fresh Ltd. operates under ideal conditions of uncertainty. In January 1, 2019, the company acquired a machine to be used in its operations. The machine is expected to last for 2 years, with no salvage value. Cash flows generated by the machine depend critically on the weather. Purchase of the machine was financed by issuing shares. In 2019, cash flows from the machine will be $700 if the weather is rainy and $200 if the weather is dry. In 2020, cash flows will be $900 if the weather is rainy and $300 if it is dry. Cash flows are received at year end. Objective state probabilities for each year are 0.3 for the rainy weather and 0.7 for the dry weather. The interest rate in the economy is 6%. In 2019, the weather is rainy. The company pays a dividend of $50 at the end of 2019. Required (Show calculations and round the results to 2 decimal places): a. Prepare the present value-based balance sheet as at the beginning of 2019 and as at the end of 2019. (6 marks) b. Prepare the income statement for 2019. (5 marks) c. Briefly explain why current value is more relevant but less reliable than historical cost. (5 marks) Question 2 (18 marks) Jimmy plans to invest $30,000 in the shares of Company A (act a) or the same amount in shares of Company B (act a) for one year. As a rational investor, Jimmy identifies two states of nature: State H: The company expects high future cash flows. State L: The company expects low future cash flows. On the basis of his information to date about each firm, Jimmy assesses the following subjective prior state probabilities (ie., the same probabilities for each company): State H: 0.8; State L: 0.2 Jimmy is risk-averse, with utility equal to the square root of the amount of net payoff received. The following is the payoff table for these two investments. Payoffs are net of the original investment. Act State H L a $3,000 $1,200 a2 $4,200 $ 800 Required (Show calculations and round the results to 2 decimal places): a. On the basis of his prior probabilities, which act should Jimmy take? Show calculations. b. Instead of acting now, Jimmy decides to obtain more information by careful reading of each company's financial statements from their latest annual reports. As an expert on GAAP and financial statement reporting, Jimmy knows if a company is really a high-state one, there is a 0.8 probability that the company will provide good news (GN) in current year's financial statements. If a company is a low-state one, there is a 0.7 probability that the company will provide bad news (BN) in current year's financial statements. These possibilities are summarized in the following information system. Current Financial Statement Information Good News Bad News H 0.8 0.2 State L 0.3 0.7 Upon reading the current financial statements, Jimmy finds that Company A has good news and Company B has bad news. Based on Company A and B's current year financial reporting, use the Bayes' theorem to compute the posterior state probabilities for Company A and Company B, respectively. (6 marks) c. Given the posterior state probabilities computed in (b), which act, a or a2, should Jimmy take now? Show calculations. Question 3 (14 marks) On December 21, 2019, Streaming Co. reported its financial results for the quarter ended November 30, 2019. Its net income increased to $386 million, or 65 cents per share, up from $190 million, or 31 cents per share, for the same quarter of the previous year. Its sales increased to $1.80 billion, up from $976 million for the previous year's quarter. These results were in line with analysts' forecasts. On the same day, the company projected further increases for next quarter, with earnings per share expected to be in the range of 70 to 80 cents. An increase in the number of customers was also projected, mainly due to the company's success in penetrating new consumer markets in foreign countries. On December 21, 2019, Streaming's share price increased from $420 to $468 per share following these announcements. The return on market index on the same day is 0.0072 (RM)- Streaming's beta is 0.83 and the risk free return is 0.0002 (R+) per day. Required: a. Calculate the abnormal return of Streaming's shares for December 21, 2019 (round the results to 4 decimal places). (4 marks) b. Assuming the securities market is efficient, explain why Streaming's share price increased on December 21, 2019. (4 marks) c. Briefly explain three ways through which Streaming Co. can increase its earnings response coefficient (ERC). Question 4 (20 marks) Jack owns a small business. He plans to take a one-year vacation, and is interviewing Mary for the position of manager while he is away. On the basis of past experience, Jack knows that if the manager works hard (a1), the cash flow (payoff) from the year's operations will be $505 with probability 0.8 and $345 with probability 0.2. If the manager shirks (a2), cash flow will be $505 with probability 0.2 and $345 with probability 0.8. Payoffs are before manager compensation. However, cash flow will not be known until some time after Jack returns and Mary demands to be paid at year end. Jack decides to base manager compensation on net income. He knows that if the payoff is going to be $505, net income will be $625 with probability 0.7 and $225 with probability 0.3. If the payoff is going to be $345, net income will be $625 with probability 0.3 and $225 with probability 0.7. Net income is before manager compensation. Upon interviewing Mary, Jack finds that Mary's reservation utility is 2.6, that her utility for money equals the square root of the amount of money received, and her disutility of effort if she works hard is 8. If she shirks, her effort disutility is 7. Jack offers Mary a one-year contract with compensation of 25% of net income before compensation. Required: (Show calculations and round the results to 2 decimal places) a. Determine whether Mary will accept the offer. Show calculations of her utility if she works hard (a) and if she shirks (a2). Also indicate whether Mary will work hard or shirk. (6 marks) b. Calculate Jack's utility if Mary works hard. Jack is risk-neutral and his utility is equal to net payoff. (5 marks) c. After signing the compensation contract, Jack realizes that Mary can opportunistically manage net income and report a net income of $625 regardless of the unmanaged net income. Using utility calculation to explain whether Mary will work hard or shirk if such earning management occurs. (5 marks) d. Sharing 25% of net income with Mary increases contracting costs to Jack. The contracting cost is partly because that net income is a noisy measure of payoff. Jack wants to improve contracting efficiency. As a student who just took Accounting Theory course, what method would you suggest to Jack to lower the profit-sharing percentage but still can motivate Mary to work hard? Question 5 (18 marks) Both the compensation theory and empirical evidence suggest that boards use a diverse set of performance measures, such as net income versus price, financial versus non-financial measures, when designing executive compensation contracts. Some recent studies find that in setting executive bonus plans, boards also select alternative accounting performance measures other than bottom-line net income. These performance measures include sales, operating income, and earnings before interest, taxes, depreciation, and amortization (EBITDA), all of which exclude certain expenses from net income. In specific, recent studies find that, in designing the executive bonus plans, (1) for firms with larger R&D expenditures and more growth opportunities, boards tend to select sales as performance measures. (2) for firms with losses from discontinued operations or restructuring charges, boards would exclude these items from net income to evaluate the manager's performance. Required: a. Briefly explain for each of the two scenarios, (1) and (2), why boards would make such adjustments when evaluating the manager's performance. (6 marks) b. How would these adjustments affect compensation risk and the length of manager decision horizon? (6 marks) c. In another recent case in 2019, Elon Musk, CEO of Tesla, Inc., received a compensation plan that consists of stock option only (a 100% option-based compensation). Discuss how such a compensation would affect Elon Musk' risk-taking behaviour and the length of his decision horizon. (6 marks) Question 6 (14 marks) As one important step in the standard-setting process, before issuing a new accounting standard, the Financial Accounting Standards Board (FASB) issues an Exposure Draft (ED) to solicit broad stakeholder comments and input. Then the FASB redeliberates and revises the proposed standard by carefully considering the stakeholder input received. Required: a. Use the interest group theory to identify who are the stakeholders (constituents) that the FASB would consult and why it is important to seek feedback from these constituents. (8 marks) b. One of the criteria for standard setting is to consider "economic consequences of new standard". List out some examples of costs of a new accounting standard. (6 marks)