Acct-Theory-Exam-Review-40 - Conestoga College ACCT 74020

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FINAL EXAM REVIEW 40% Question 1 “It is Possible to reduce risk in a portfolio by diversification.” Required: a. Do you agree with this statement? Explain why or why not. b. Can this risk of ... a portfolio be reduced to zero by diversification? Explain. Answer: a) It is possible to reduce risk by diversification because more than one risky asset is part of investment. So firm specific risk will cancel out if securities are not perfectly correlated. If one share is giving low return, possibility of getting higher return from another share in the portfolio. This reduces the variance of return as a result low risk of portfolio. Example: if you have purchased shares of google or amazon and aircanada than possibility of higher return from google and amazon and low return or losses from aircanada. This situation is better as compare to an investor who invested only in one firm like aircanada. b) Risk can not be reduced to zero due to economy wide factors effect on share market. Systematic risk – market risk is always there in share market investment. Like due to COVID 19, most of the firms have been affected. There is no production, no sale, no earnings. So risk is always associated with market investment. Question 2 Decision usefulness is an important accounting concept. Required: a. State the decision usefulness approach to accounting theory. Decision useful approach is an accounting theory approach which analyze the financial statement user’s information needs by studying their decision problems. b. What two questions arise once the decision usefulness approach is adopted? Who are the financial statement users? What are their decision problems? c. What primary constituency of financial statement users has been adopted by the conceptual framework as a guide to the reporting of decision useful financial information? What information does this constituency need according to the framework? Primary constituency of financial statement users is present and potential equity investors, lenders and creditors (also known as primary user group). Primary user group need information about timings, amount and uncertainty of future cash flows. d. What features does financial accounting information need if it is to be useful to the constituency identified in part c? Basic feature is that financial statement information should create a difference in users decision about investment. Information should be relevance and reliable. e. Explain why information about the riskiness of securities is useful to investors Investors are assumed to risk averse. If risk is associated with an investment, they would like to get higher return. So they need information about risk and return associated with an investment in a firm. Question 3 What sort of portfolio would risk taking investor be likely to invest in? what information would the investor need? Answer: A risk-taking investor will specialize (that is, buy only one security) — the one with the highest risk for a given expected return. There is no incentive to diversify for an investor who likes risk. A risk-taking investor needs the same information as any other investor — information that will be useful in assessing expected returns and risks of securities. However, risktaking investors will use the information differently. They will seek to find the securities that, for a given return, have the highest risk. Question 4 Kim and Cross study reported that the ability of current earnings to predict next period’s operating cash flows exceeds the ability of current operating cash flows to predict next period’s operating cash flows. Give an explanation for this result. Answer: The reason for the Kim and Cross finding is that net income is determined on an accrual basis. Since accruals anticipate future cash flows, they remove the lumpiness that operating cash flows often exhibit. For example, revenue recognized from a large sale near the end of the period may not be collected in cash by the end of the period, yet all or most of the cash outflows associated with the sale may have been incurred. Then, operating cash flows for the period would not predict future cash flows as well as net income for the period Question 5 Based on estimation risk Using the concept of information asymmetry, answer the following questions: a. you observe that used car sold by new car dealers sell for higher price, for models of same make, year and condition, than used cars sold by used car dealers. Why? This occurs if the market perceives the new car dealer as more reputable than the used car dealer. Then, estimation risk of buying a used car is low. For example, the new car dealer may stand behind used cars sold to a greater extent than the used car dealer. The new car dealer may offer a superior warranty. Also, it may be perceived that the new car dealer will be in business longer; therefore, better able to honour the warranty. In effect, the market perceives the average quality of used cars sold by the new car dealer as superior, and thus buyers are willing to pay more b. Why would a fire insurance policy contain a $1,500 deductible provision? This question illustrates the moral hazard problem. Homeowners will exert less effort to prevent fire if they know the insurance company will reimburse them for the full amount of losses. By sharing in any loss, homeowners are motivated to be more careful. The moral hazard problem arises because of information asymmetry — the insurance company cannot directly observe the effort devoted by homeowners to prevent fires. If direct observation were possible, payment of a claim could be made contingent on satisfactory prevention efforts, and a deductible would not be needed c. Why would a life insurance company require a medical examination before approving applications for new policies? Life insurance companies have such a requirement because of the adverse selection problem. Life insurance applicants know more about their health than the insurance company does. Thus, people of poor health will have a greater incentive than healthy people to take out a policy. In the face of this information asymmetry, the insurance company has a doctor examine the applicant d. A firm plans to raise additional capital by means of a new issue of common share. Before doing so, it hires a well known investment house to help design and market the issue, and also, switches auditors from a small, local firm to a big four firm. Why? The answer is similar to part a. There is information asymmetry between the seller and the buyers of the new share issue because the firm will know more about its current position and future prospects than the buyers. An efficient market thus knows that it is facing an adverse selection problem. To reduce estimation risk surrounding the share issue, the firm engages a reputable investment house and a prestigious auditor to credibly convey to the market that the information contained in the prospectus is reliable. The information is credible because the market realizes that the firm would not hire reputable, and presumably expensive, professionals to attest to misleading or poor quality information Question 6 On February 27, 2007, Laurentian Bank of Canada released results for its first quarter, ending on January 31, 2007. It reported profit of 74 cents per share (70 cents per share before a non recurring gain). Analysts’ estimates of profit for the quarter were 65 cents per share. For the same quarter of the previous year, profit was 59 cents per share. Total revenue increased 6%. The bank announced a quarterly dividend of 29 cents per share, unchanged from the two previous quarters. The CFO of Laurentian stated that its loan exposure to struggling forestry and manufacturing firms was better, although there was still room for improvement. Laurentian’s shares are traded on the S&P/TSX exchange. The TSX index rose 5 points on February 27, closing at 13,040.11. Laurentian’s share price fell 34 cents for the day, to $30.71. Required: Why did Laurentian’s share price fall? Assume efficient securities markets and consider both economy wide and firm specific factors in your answer. Solution: Economy-wide factors do not seem to be the reason for the fall in Laurentian’s share price, since the TSX market index rose slightly for the day. The fall was likely due to firm-specific (i.e., idiosyncratic) factors. Since earnings increased from the same quarter of the previous year, even after factoring out a non-recurring gain (gain on sale of asset, insurance gain – one time gain), and exceeded analysts’ estimates (.70-65 cents), this would exert upward influence on share price. Bad news items must have outweighed this good news. Possible reasons for the fall are: • Continuing investor concerns about loan quality, particularly in view of the CFO’s statement that there was still room for improvement. • The dividend did not increase, despite higher earnings. This suggests that management may have concerns about future cash flows and earnings, possibly driven by loan quality issues Question 7 Concept Ltd. is a listed public company. It is in a volatile industry. The market price of its shares is highly sensitive to its earnings. The company’s annual meeting is to be held soon and the president is concerned, expecting to be attacked strongly by a dissident group of shareholders. One issue the dissidents are expected to focus on is the company’s amortization policy. They will claim that the annual declining balance amortization changes are excessive – that the company’s conservative amortization policy seriously understates annual earnings per share, causing the share’s market price to be artificially low. Threats have been made of suing management and the BOD to ‘recover the resulting loss in market value, relative to shareholders in companies with less conservative amortization policies, suffered by concept’s shareholders.” The president had asked you to help prepare a defence against the expected attack on the company amortization’s policy. Required: Write a memo summarizing how you would recommend the president respond to this attack. Solution: The main point that must be made in your memo is that efficient securities market theory suggests that the market will see through the declining balance amortization policy and will not penalize the firm for any resulting lower reported net income. Thus, there will be no “loss in market value.” It should be noted that for the market to see through the firm's depreciation policy, the policy that is used must be disclosed. Presumably, this is the case since the dissident (a group of shareholders who oppose management and board of director) group of shareholders knows the policy. A good answer will go on to point out that the declining balance amortization has several potential advantages for Concept Ltd. Since capital assets are amortized relatively quickly under declining balance, the assets thereby retained in the business will serve as a hedge against obsolescence, which is appropriate if the environment is volatile. Also, the firm's use of a conservative amortization method (under this method, asset value is considered low and depreciation high, value of asset decrease at a high rate, wear and tear considered high so high depreciation each year as a result low profit) can be a credible signal that the firm's future earning power can stand the higher depreciation charges. This may cause investors to place a higher value on the firm so that the market price of Concept's shares could actually rise, rather than fall, as a result of the conservative policy Question 8 Give examples of components of net income with a. High persistence b. Persistence of 1 c. Persistence of 0 Assume that the firm uses historical cost accounting. A) Examples of components of net income with high persistence include permanent changes in sales, as a result, say, of changes in competition, new technology, successful patents, or acquisitions. Permanent cost changes resulting from improved technology, reorganizations, or economies of scale, would also have high persistence. B) Realized gains or losses that are not expected to recur will have persistence of 1. Gains or losses on disposals of capital assets are examples, to the extent they are not expected to recur and are not part of the firm’s normal operating activities. However, they do generate realized income and the abnormal market return will reflect this. For example, if a firm realizes a $100,000 gain on sale of land, the assets of the firm increase by $100,000, and the firm’s market value will increase by this amount (it would have increased earlier if the market had anticipated the value increase). However, market value will not increase by more than this amount if the gain is not expected to persist. Hence, persistence is 1. C) Zero-persistence items can result from accounting policy choices that have no cash flow effects. For example, if a firm capitalizes organization costs, staff training costs, or advertising costs, net income is higher than it would be if these items were expensed. But an efficient market would not react to the increased reported earnings thus created since the decision to capitalize or expense has no effect on cash flows (the cash is spent either way). In effect, these items are valueirrelevant. Persistence can also be zero for gains or losses resulting from accounting policy changes. For example, suppose that a firm reports an increase in income this year because it has changed from declining balance to straight line amortization for its property, plant, and equipment. An efficient market would not respond to such a change as long as it felt that there were no effects on cash flows. Question 9 Is a negative ERC possible? Explain why or why not. ERC (Earning response coefficient) = Abnormal Return/Unexpected earnings Answer: Yes, a negative ERC is possible. This means that the firm reports positive unexpected earnings but the ab [Show More]

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