Management Development Institute MANAGEMENT 101 ACCM 4600 - Solutions Tutorial 9

8.3 Explain why accounting earnings do not capture all the information contained in share prices. (LO3) Accounting earnings do not capture all the information contained in share prices because they are calculated usin ...

8.3 Explain why accounting earnings do not capture all the information contained in share prices. (LO3) Accounting earnings do not capture all the information contained in share prices because they are calculated using the conservative principles of revenue realisation and expense matching which do not recognise all the events that are incorporated into share prices. Additionally, these principles result in bad news being disclosed in a more timely manner than good news, reflecting the less stringent accounting recognition criteria for bad news. 8.5 What is meant by the term ‘post-earnings announcement drift’? What implications does this phenomenon have for the efficient market hypothesis? (LO3) ‘Post earnings announcement drift’ refers to the evidence that stock markets underreact to earnings information — there is not an instantaneous, complete reaction to value-relevant information but rather a gradual adjustment to the information. This gradual adjustment contradicts the EMH which assumes that markets react instantaneously and completely to all value-relevant information. 8.9 International accounting standards are conservative in their treatment of intangibles. Will this conservative treatment conflict with investors’ perceptions of the value of intangibles to a firm? (LO6) Accounting’s conservative treatment of intangibles (largely they are expensed) conflicts with investors’ perceptions of the value of intangibles to an entity. The costs of intangible assets have been shown to be relevant to investors, but investors perceive the expenditures as capital acquisitions, in contrast to the accounting treatment of expensing such expenditures.Suggested Solutions taken from the Solutions Manual to accompany Rankin, Ferlauto, McGowan and Stanton. Contemporary Issues in Accounting © 2018. Page 2 of 7 8.22 In December 2015, OZ Minerals wrote down its assets by $201 million. In its 2017 accounts it reversed this impairment charge, recording an increase of $141.1 million to net profit. The impairment reversal was a non-cash adjustment — it did form part of OZ Minerals’ operating earnings. As a result, the market was reported to have found the reversal of historic interest only. However, after the announcement of its 2017 earnings, OZ Minerals’ share price outperformed the broader mining market, rising by over 3%. If the reversal was of ‘historic interest only’, how can the share price reaction be explained? (LO3) Intuitively, the increase in net profit should result in an increase in the share price as an increase in net profit is good news; good news is expected to increase share price. The impairment reversal may have been part of earnings management. The EMH suggests that investors should see through cosmetic earnings management but behavioural theory suggests otherwise. Investors decisions are multifaceted, easily changed and seek satisfactory solutions rather than optimal ones. Perhaps the 2017 earnings announcement was “satisfactory”. 8.27 For the 2016 financial year, Clean Water Solutions had: • revenues from ordinary activities up by 79% • earnings before depreciation, amortisation, tax and interest improved by 40% • net loss for the period improved by 33% over the previous year’s loss. (a) What would you intuitively expect to be the market reaction? (b) Over the following two weeks, the company’s share price fell by a third. The directors could not offer a business reason for the fall. Can you suggest a reason(s) for the fall? Explain your reasoning. (LO5 and LO6) (a) Intuitively the share price should have risen in response to the ‘good news’ (b) Answers should be assessed by the student’s argument behind their explanation – such as that the fall was due to the market having already factored in an even stronger improvement than eventuated. In other words, the market may have been expecting a better performance and so the results need to be benchmarked against the market’s expectations, not against the prior financial year. An alternative explanation may focus on the irrationality of the market in some situations or on other offsetting (negative) information not included in the question.