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financial accounting theory
Questions and Answers of
Financial Accounting Theory
On May 16, 2002, The Toronto-Dominion Bank (TD) announced that it would voluntarily begin expensing its executive stock options, effective for its fiscal year beginning November 1, 2002. This
On October 7, 2000, The Globe and Mail reported that Air Canada had slashed its third and fourth quarter 2000 earnings forecasts. The company had revealed this information by phone calls to a select
On September 13, 2005, the shares of Best Buy Co. fell $5.14 to $45.22 on the New York Stock Exchange, a decline of 10.2%. The decline followed the release of its second quarter 2005 financial
Information has both costs and benefits to a firm. What are the costs and benefits of information production to a firm? How much information should the firm produce?
Explain why a voluntary forecast can be an indirect signal but a mandated forecast can- not.
"Contracting internalizes the problem of information production." Explain what this statement means.
Describe the difference between a direct and an indirect signal, using the quality of forward- looking information and risk disclosure in MD&A (see Section
8.2) as an example.
To what extent do (i) security market forces and (ii) managerial labor market forces operate to motivate managers to operate their firms in the best interests of the shareholders? In your answer,
An adverse selection problem can arise from information asymmetry between issuer and buyer of securities.Requireda. Explain what the adverse selection problem is in this context.b. How can financial
The failure of managers to release bad news is a version of the adverse selection problem. Such failure indicates that the securities market is not working well. Requireda. Why might a manager
On September 15, 2004, the Dow Jones Industrial Index suffered its largest fall in a month, dropping by0.8% or86.8 points. The Standard and Poor's 100, 400, and 500 indices also dropped by similar
In February 1998, Newbridge Networks Corp., a telecommunications equipment maker based in Kanata, Ontario, announced that its revenues and profits for the quarter ending on February 1, 1998, would be
On March 15, 2004, Canadian Superior Energy Inc held a conference call concerning the recent abandonment of its Mariner E-85 exploration well off the coast of Nova Scotia. The company's CEO explained
Imax Corp. is a large entertainment technology company, with headquarters in New York and Toronto. Currently, it has 266 theatres in 38 countries. Its share price, which was as high as $13.89 on the
In The Wall Street Journal, June 30, 1997, Suzanne McGee describes how institutional investors, such as mutual fund managers, are searching for highly liquid stocks to invest in. If the market for a
The following article by John Partridge appeared in The Globe and Mail, August 23, 2001.It discusses the decision by Canadian Imperial Bank of Commerce (CIBC) to discontinue separate disclosure of
In November 2006, the financial media reported a 12-year jail sentence to Sanjay Kumar, ex-CEO of Computer Associates International, a large computer software company (now called CA Inc.). In
A number of firms, such as BCE Inc., Coca-Cola, and McDonalds, have discontinued their practice of issuing quarterly earnings forecasts, thereby lowering their disclosure quality. The reason usually
General Electric Corp. (GE) is a large and complex United States-based conglomerate, with operations extending from industrial and medical equipment to aircraft leasing and mortgage lending, its
The interest group theory of regulation predicts constituency conflict surrounding the design and implementation of new accounting standards.Requireda. Describe how the structure of standard setting
Numerous countries have adopted, in whole or in part, IASB accounting standards. Canada plans to adopt IASB standards from 2011. What are some of the benefits and costs to a country of adopting IASB
In March 2004, the FASB issued an exposure draft of a standard proposing the expensing of ESOS. However, the proposal faced powerful opponents. These included large corporations such as Texas
The article here reproduced from The New York Times (October 12, 1997) describes pressures to “kill” the FASB, and hand its duties over to the SEC. The reason for the pressure seems to be due to
JAS 39, Financial Instruments: Recognition and Measurement, requires companies using IASB standards to fair-value many financial instruments including derivatives, effective January 1, 2005. This
In a June 2007 article in The New York Times, Floyd Norris discusses recent moves by the SEC to speed up its proposed halting of reconciliation to US.GAAP by foreign companies whose shares are traded
In its report to shareholders for its quarter ended April 30, 2007, TD Bank Financial Group reported the following items ($ million) in other comprehensive income: - Change in unrealized gains and
99%;" height="132">Note: For purposes of this question, treat the relevant provisions of the CICA Handbook as identical to SFAS 115, SFAS 130, and SFAS133.Requireda. Explain the nature of each of
Refer to Theory in Practice13.1, concerning SFASS 130 and 115, in Section13.3.2Requireda. Why does SFAS 115 require unrealized gains and losses on available-for-sale securities to be included in OCI
The Sarbanes-Oxley Act was passed by the U.S. Congress in 2002, following financial reporting disasters of Enron Corp. and WorldCom Inc. (see Section1.2). Section 404 of the act requires that senior
Below is a portion of a 2008 proxy form sent to shareholders of Miracle-J Corporation. It reveals that Miracle-J has a bonus plan for its three senior executives that allocates them 10% of before-tax
In the BCE compensation plan, outlined in Section 103, short-term incentive awards are based less heavily on corporate performance and more on individual creativity and initiative as the employee is
Microsoft Corp. announced in 2002 that it was discontinuing its employees' stock option plan in favor of restricted stock, vesting over a five-year period. At that time, many of its already-granted
In its 2004 proxy statement to shareholders, the compensation committee of General Electric Company (GE) reported that in 2003 it had discontinued ESOs for its CEO, Jeffrey Immelt. In their place, GE
In 1993, the Ontario Securities, Commission implemented new executive compensation disclosure rules (OSC, Form 40, Securities Act, Regulation 638/93). Similar requirements were already in place in
On November 18, 2002, The Globe and Mail (p. B4) reported “CEO assails pay disclosure rules.” This referred to a speech by Claude Lamoureux, CEO of Ontario Teachers Pension Plan Board. The board
Refer to Theory in Practice10.2 in Section10.6 concerning BCE Inc. Reproduced on p. 395 are the 1997 consolidated statement of operations and Note 2 to the financial statements of BCE. The statement
Many firms “reprice” ESOs following major declines in their share price by lowering the exercise price. This is because ESOs issued before the decline are deep out of the money, hence unlikely to
In January 2007, Zions Bancorporation announced that it had received SEC permission to use a market-based approach to valuation of its ESOs. Zions is a large U.S. financial services company that
Grein, Hand, and Klassen (2005) studied the stock price reaction to repricing of ESOs. They examined a sample of 72 Canadian companies that repriced ESOs during 1994-2001.They found a4.9% average
Ittner, Larcker, and Rajan (1997) studied the relative weights placed on financial and nonfinancial performance measures in CEO bonus contracts for a sample of 317 U.S. firms across 48 industries for
Note: This question integrates several topics from earlier sections of the text.UnitedHealth Group, Inc. is a large U.S. health insurance company. In a May 11, 2006, SEC filing, the company revealed
Refer to Theory in Practice4.2.RequiredThe Kmart CEO charged by the SEC was hired in May 2000 and fired in March 2002.Despite Kmart losses of $3.9 billion for the five quarters ended April 2002, the
For an income management strategy of taking a bath, the probability of the manager receiving a bonus in a future year rises. Explain why.
You are a CEO operating under a bonus plan similar to the one assumed by Healy(Section11.3). Explain whether you would react favorably or negatively to an exposure draft of a proposed change in GAAP
The firms in Healy's study of earnings management (Section11.3) would have been using the historical cost basis of accounting. Given that accounting standards have moved to fair value accounting for
The comparative balance sheet of JSA Ltd. as at June 30, 2008 is as follows:JSA Ltd.'s 2008 income statement is as follows:Requireda. Calculate the various accruals on an item-by-item basis. For each
The potentially serious consequences of bad earnings management are illustrated by the case of Atlas Cold Storage Income Trust, which operates a system of refrigerated warehouses across Canada and
General Electric Company (GE) is a large United States-based conglomerate, with operations extending from a large variety of industrial equipment and services, to healthcare, to TV and entertainment,
The article “Dangerous Games,” by Jonathan Laing is here reproduced from Barron’s(June 8, 1998). The article describes apparent earnings management devices used by Sunbeam Corp., with
Barton (2001) studied managers’ use of derivatives and discretionary accruals to smooth reported earnings. As Barton points out, both of these devices have smoothing potential—since earnings can
Refer to Theory in Practice11.1 in Section11.6.Requireda. Which earnings management policy did Nortel appear to be using in 2001 and 2002?Why? Which policy did it appear to be using in 2003? Why?b.
You are an expert on generally accepted accounting principles and the quality of financial reporting, with extensive experience in rational investing. You determine the current quality of financial
On March 10, 2006, Nortel Networks Corp. announced that it would delay filing its 2005 financial reports with the SEC. The delay arose because Nortel and its auditors decided that certain revenue
In April 2005, the SEC announced settlement with Coca-Cola Company of charges of fraud and false and misleading financial reporting. The charges arose from “gallon pushing”at Coca-Cola's Japanese
On October 3, 2007, Deutsche Bank AG announced that it would record a write-down of EUR2.2 billion. Most of the write-downs applied to its investments in asset-backed securities and related financial
Why is manager effort usually unobservable to the firm’s owners? What problem of information asymmetry results? If the manager receives a straight salary, what is the effect of this information
Give some reasons why the payoff from the manager's current-period effort is typically not fully observable until a subsequent period.
If net income is an unbiased (i.e., noisy) measure of manager performance, less noise enables a more efficient compensation contract. Explain why. Suggest ways that accountants can reduce noise in
Why do debt contracts typically impose covenants based on accounting information such as working capital, interest coverage, and debt-to-equity?
Why is net income not fully informative about manager effort? .
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
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