AFM 401 Textbook Summary [Full Course] File contains concise, easy-to-read summaries of assigned textbook readings. Readings arranged chronologically by when they were assigned for ease of use; organized by chapter for increased readability.

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Accounting & Financial Management
AFM 401
Satiprasad Bandyopadhyay

Chapter 1 – Introduction - Information Asymmetry occurs when one party to a business transaction has more information or is better informed than the other party. There are two main types of information asymmetry: o Adverse Selection is a type of information asymmetry whereby one or more parties to a business transaction, or potential transaction, have an information advantage over other parties (e.g., the manager of a firm has much more information about the firm than an outside investor). It is so named because these insiders may execute tactics which are adverse to the interests of ordinary shareholders o Moral Hazard is a type of information asymmetry whereby one or more parties to a business transaction, or potential transaction, can observe their actions in fulfillment of the transaction but other parties cannot (e.g., it is impossible for investors/shareholders to observe directly how hard a manager is working on their behalf. The manager may then attempt to avoid any accountability by blaming any deterioration in net income on factors outside of his control, or biasing reports to cover these things up - Under Ideal Conditions we mean an economy where firms’ future cash flows and their probabilities are known, and has perfect and complete markets or, equivalently, a lack of information asymmetry and other barriers to fair and efficient working of markets - The reporting of information that is useful to rational investors is called the Decision Usefulness Approach. This approach underlies the pronouncements of major standard setting bodies, such as the IASB/FASB Framework. There are two versions of decision usefulness: o Information Approach: This perspective takes the view that the form of disclosure does not matter – it can be in the notes, or in supplementary disclosures such as reserve recognition accounting and management discussion and analysis, in addition to the financial statements proper. Rational investors are regarded as sufficiently sophisticated on average that they can digest the implications of public information from any source o Measurement Approach: Under this perspective, accountants expand their approach to decision usefulness by taking more responsibility for incorporating measurements of current asset and liability values into the financial statements proper - Standard setting bodies: o The International Accounting Standards Board (IASB)  International Standards (IFRS) o The Financial Accounting Standards Board (FASB)  United States Standards (US GAAP) o The Canadian Accounting Standards Board (AcSB) o Securities Commissions - The fundamental problem with Financial Accounting Theory is that the best measure of net income to control adverse selection is not necessarily the same as the best measure to motivate manager performance Chapter 2 – Accounting Under Ideal Conditions - The Present Value Model provides the utmost in relevant information to financial statement users o In this context we define Relevant information as information about the firm’s future economic prospects, that is, its dividends, cash flows, and profitability o Reliable information faithfully represents the firm’s financial position and results of operations - The Accretion of Discount is the opening present value multiplied by the interest rate o Accretion: The process of growth or increase, typically by the gradual accumulation of additional layers or matter o The term arises because the stream of cash receipts is one year closer at the end of the year than it was at the beginning - Under ideal conditions, the book value of a capital asset will be the present value of its future cash flows (it’s Value-In-Use). Net Income is the present value of future cash flows multiplied by the interest rate - Under ideal conditions, dividend policy does not matter as long as investors can invest any dividends they receive at the same rate of return as the firm can earn on cash flows not paid on dividends, the present value of an investor’s overall interest in the firm is independent of the timing of dividends. This is known as Dividend Irrelevancy - Uncertain future events such as the state of the economy are called States of Nature - The Abnormal Earnings, or Unexpected Earnings, is the difference between the expected earnings calculated using expected cash flows and the probabilities of States of Nature, and the actual earnings. This can be a gain or loss - Present value accounting applied to oil and gas reserves is known as Reserve Recognition Accounting (RRA). The RRA model seems very similar to the present value model under uncertainty, except that it is necessary to make material changes to previous estimates o The reliability of RRA accounting is a concern. Even though proved reserves are allowed to be recorded, that judgement is still subjective. Also, estimates are, as always, subject to error - Some argue that Historical Cost Accounting is more useful to investors than current value accounting. The basic argument is that past performance is the best predictor of future performance. By providing a reasonably reliable measure of accomplishment (i.e., realized revenues) and effort (i.e., the allocated costs of earning those revenues), the firms current and past earnings performance represents the foundation upon which projections of future earnings can be based. Some of the characteristics of historical cost accounting in relation to current value: o Relevance vs. Reliability: Generally, historical cost accounting is more reliable than current value accounting since it is based on actual transactions which have transpired. Current value accounting is simply an educated estimate. However, current cost account is seen as more relevance, current cost accounting is seen as superior because historical costs have likely changed since they were incurred depending on multiple factors o Revenue Recognition: Using RRA as an example, valuing proved reserves at current value (i.e., the standardized measure) implies revenue recognition as reserved are proved. More generally, current valuation of assets and liabilities implies revenue recognition as changes in current value occur. Under historical cost, valuation of inventories at cost and accounts receivable at selling price implies revenue recognition as inventory is sold. Thus, current value accounting implies earlier revenue recognition than under historical cost o Recognition Lag: The concept of recognition lag represents the extent to which the timing of revenue recognition lags behind changes in real economic value. Current value accounting has little recognition lag, since changes in economic value are recognized as they occur. Historical cost has a greater recognition lag, due to the fact that revenue is not recognized until increases in inventory value are validated, usually through realization as sales. As a result, revenue recognition under historical cost lags increases in economic value of inventory o Matching of Costs and Revenues: Matching is primarily associated with historical cost accounting, since net income under historical cost accounting is a result of the matching of realized revenues with the costs of earning them through the use of accruals (e.g. AR, AP, Amortization, etc). Accruals “smooth out” cash flow so as to allocate them over the periods to which they relate. There is little matching under current value accounting, since net income is then an explanation of how current values of assets and liabilities have changed during the period. Matching is not required for this since value changes in assets and liabilities are driven by market forces and the firm’s response to these forces - In the case of current value account, as was witnessed in the description of RRA, net income does not exist as a well-defined economic construct. A fundamental problem is the lack of objective state probabilities (e.g., good, bad) - There is also an issue of potential Incomplete Markets, that is, if there is not a ready market value for an asset or liability, an income measure based on changes in market values is not possible Chapter 3 – The Decision Usefulness Approach to Financial Reporting - The Decision Usefulness Approach takes the view that if we can’t prepare theoretically correct financial statements (due to the complications and shortcomings of the present value model), we can at least try to make financial statements more useful. In adopting the decision usefulness approach, two major questions must be addressed: o Who are the users of financial statements? o What are the decision problems of financial statement users? - Single-Person Decision Theory takes the viewpoint of an individual who must make a decision under conditions of uncertainty - Decision Theory makes use of Bayes’ Theorem to calculate a decision-makers Posterior State Possibilities - ( | ) ( ) ( | ) ( ) ( | ) ( ) ( | ) o P(H|GN) = The (posterior) probability of the high state given the good news financial statement o P(H) = The prior probability of the high state o P(GN|H) = The probability that the financial statements show good news given that the firm is in the high state o P(L) = The prior probability of the low state o P(GN|L) = The probability that the financial statements show good news given that the firm is in the low state o In this case the P(L|GN) would simply be [1 – P(H|GN)] - Despite the fact that financial statements do not report directly on future cash flows by means of present value based calculations, they can still be useful to investors to the extent that the good news or bad news they contain will persist into the future - When deciding whether or not to switch to a different accounting method, we must look closely at the relevance/reliability trade-off; our goal is increase informativeness of the financial statements. For example, switching to value-in-use accounting would make financial statements much more relevant, but also less reliable due to the use of estimates. This transition should only be undertaken if it can be shown that the statements are now more informative due to its greater relevance outweighing the decrease in reliability - Information is evidence that has the potential to affect an individual’s decision - Individuals may differ in their reaction to the same information, even for similar decisions. Their prior probabilities and utilities may differ, so that posterior probabilities, and hence their investment decisions, may differ even when confronted with the same evidence - In general, information is deemed relevant if it gives information to investors about the firm’s future economic prospects; and information is reliable if it faithfully represents what it is intended to represent - The decision usefulness approach has been adopted by major standard setting bodies such as the IASB and FASB, as reflected in their conceptual framework Chapter 4 – Efficient Market Securities - Information is free under ideal conditions, unfortunately this is not the case in less than ideal conditions, and so investors have to determine how much accounting expertise and information to acquire, and then form their own subjective estimates of the firm’s future performance - The definition we will focus on is Semi-Strong Form Market Efficiency, under which the price of securities traded on that market at all times fully reflect all information that is publically known about those securities o This form contrasts with Strong Form Efficiency, under which security prices reflect all information, not just information that is publically available o From here on when we say market efficiency we mean semi-strong efficiency - Market efficiency is a relative concept; the market is efficient relative to a stock of publically available information. There is nothing in the definition to suggest that the market is omnipresent and that market prices always reflect real underlying value , as they would under strong-form efficiency - The concept that the differences in forecasting ability between investors is cancelled out when a general market consensus is formed will only hold if we assume that individual decisions are independent. If forecasters got together to work out and agree on a forecast, then this argument would break down - Implications of Efficient Market Securities (According to W. H. Beaver, 1973): o (1) Accounting policies adopted by the firm do not affect their security price, as long as these policies have no differential cash flow effects, the particular policies used are discussed, and sufficient information is given so that the reader can convert across policies. This assumes that the market can see through different accounting policies to the actual cash effects underneath o (2) Efficient security markets go hand-in-hand with full disclosure. If a firm’s management possesses relevant information about the firm and if this can be disclosed at little or no cost, management should then disclose this information on a timely basis unless it is certain that the information is already known to investors from other sources. This gives the market more information with which to adjust your earnings estimates with and make them more relevant, and two, it gives investors confidence that there is no insider information if the company is very transparent o (3) Firms should not be overly concerned about the “naïve investor”. The reasoning as explained by Fama (1970) is that as long as enough investors understand the disclosed information, then the market price of the firm’s shares is the same as it would be if all investors understood it. This is because the naïve investors can hire their own experts to interpret the information for them, or they can mimic the buy/sell decisions of informed investors. This is referred to as investors being Price-Protected by the efficient market o Accountants are in competition with other providers of information, such as websites and other media - One logical inconsistency with market efficiency is that if market prices already reflected all publically available information, then average investors could never be expected to beat the market, and thus not bother collecting information whatsoever. However, once enough investors stopped doing this, the price of the security would no longer reflect all available information because investors stopped collecting it. They would then re-realize the value in doing so and the price would reflect all available information once again. And the cycle would continue… Therefore, something else must also be acting upon the buy/sell decisions of other investors - Liquidity Traders/Noise Traders are people who do not base buy/sell decisions on rational evaluation of information, but rather on some other criteria (e.g., need some extra cash, received a “hot tip”, etc). Noise traders may affect the price of a stock, and also the decisions of other rational investors (i.e., is price higher than expected because I am missing some information, or due to excess noise trading?), For this reasons security prices are said to be Partially Informative in the presence of noise trading - Management may also make Voluntary Disclosures which go beyond what is required by GAAP, but should be regarded with scepticism since management will not want to reveal any negative information or information that would give away competitive advantage. Management may also use voluntary disclosures to signal its future intent or indicate that it is confident about future earnings - The Sharpe-Lintner CAPM: o = Market price of firm j’s shares at the end of the period t o = Dividends paid by firm j during period t o = The market price of firm j’s shares at the beginning of period t o This reflects the realized rate of return on a security - - Information asymmetry can work both ways (e.g., insurance company offering you a plan to cover you against the chance of not getting your professional designation, you have a big advantage over them) - If investors fear information asymmetry enough they will reduce the amount they would be willing to pay for shares to compensate for this estimated loss due to insider trading - Investors are aware of the information asymmetry between them and managers and the temptation on their part for adverse selection. If they do not have enough information to distinguish between good or bad investments they will simply lower the price they are willing to pay. This is a process called Pooling. This gives managers motivation to avoid pooling by providing high quality information so investors can see that they are a good purchase (if they are a good purchase of course) - The Fundamental Value of a share is the value it would have in an efficient market if there is no inside information. That is, all information about the share is publicly available. Fundamental value is a theoretical ideal - Financial reporting can be seen as a way to control the adverse selection problem and estimation risk, thereby improving the working of securities markets and reducing incompleteness - Securities markets that work well are important as a whole because in a capitalist society they are the primary vehicle whereby capital is raised and allocated to competing investment needs. By improving the quality of financial reporting, accountants hope to provide enough information to provide a level playing field for all investors. If the playing field is not level, the risk is that investors will withdraw from the market, and then the markets will become Thin, or lose their Depth. Depth is the number of shares that investors can buy or sell without affecting the market price - The social benefits of securities markets that work reasonably well will be attained if the following two conditions are met: o All useful information is publically available, at least up to the ability of penalties and incentives to cost-effectively motivate high quality reporting o Securities market prices are efficient relative to publicly available information Chapter 5 – The Information Approach to Decision Usefulness - The equating of usefulness to information content is called the Information Approach to decision usefulness of financial reporting, an approach that dominated financial accounting theory and research from 1968 until relatively recently, yielding to an approach which will be discussed in chapters 6 and 7. The information approach recognizes individual responsibility for predicting future firm performance and concentrates on providing useful information for this purpose. The approach assumes securities market efficiency, recognizing that the market will react to useful information from any source, including financial statements - However, accountants cannot claim that the best accounting policy is the one that produces the greatest market response. Information affects people differently - When evaluating the market response to earnings releases, researchers use the day the firm’s net income was reported in the financial media (e.g. The Wall Street Journal). Any good or bad news reported regarding net income is usually evaluated relative to what investors expected. They must also take into account any external events which are having an impact on the period being invested - Abnormal Return is the difference between actual return and expected return. You could also describe it as the rate of return on a firm’s shares for day X after removing the influence of market-wide factors - The Ball and Brown Study o BB were the first to provide convincing scientific evidence that firm’s share returns respond to the information content of the financial statements. The type of research used is called an event study o BB examined a sample of 261 NYSE firms over 9 years from 1957 to 1965 o They concentrated on the information content of earnings almost exclusively. Their first task was the measure the information content of earnings, that is, whether reported earnings were greater than what the market expected (GN), or less than expected (BN) o One comparable (proxy) they used was last year’s actual earnings (higher than last year = GN, lower than last year = BN) o Next task was to evaluate the market return on the shares of the sample firms near the time of each earnings announcement, this was done according to the abnormal returns procedure o Results: If we took all the GN earnings announcements in the sample, the average abnormal security market return in the month of earnings release was strongly positive. Conversely, the average abnormal return for the bad news earnings announcements in the sample was strongly negative o The results also suggested that the market began to anticipate the GN/BN as much as a year early, with the results that returns accumulated steadily over the period o Analyzing the findings over a narrow window would lead you to believe that the net income results were the source of the changes in value since few other events happened during that time. However, taking a wider window view tells us that accounting info is likely not the source, but at the most associated with the change in value - The Earnings Response Coefficient (ERC) measures the extent of a security’s abnormal market return in response to the unexpected component of retained earnings of the firm issuing that security. To calculate ERC, divide abnormal share return (for the window surrounding the date of earnings release) by unexpected earnings for the period. This measure abnormal return per dollar o abnormal earnings, enabling comparisons of ERCs across firms and over time - Reasons for Differential Market Response (variance of ERC): o Beta: The higher the beta is, the lower the demand for a high-risk stock after it releases GN earnings information, because this would increase portfolio risk. Lower demand implies a lower increase in market price and share return in response to the GN, hence, lower ERC o Capital Structure: For highly levered firms, much of the good news goes to debt holders instead of shareholders, since debt holders are the primary claimants. Therefore the ERC for a highly levered firm should be lower than that of a firm with little or no debt o Earnings Quality: We define the quality (informativeness) of earnings by the magnitude of the main diagonal probabilities. Higher probabilities = higher ERC, since investors are better able to infer future firm performance. Other dimensions of earnings quality are available, such as Earnings Persistence. We would expect ERC will be higher the more the good or bad news in earnings is expected to persist (i.e., if earnings were due to some temporary gain which could not be replicated, the ERC would not be very large). There are three types of earnings events:  Permanent, expected to persist indefinitely  Transitory, affecting earnings in the current year but not future years  Price-irrelevant, persistence of zero o A second dimension of earnings quality is Accruals Quality, it focuses on the net income equation: Net Income = Cash Flow from Operations +/- Accruals. To measure accrual quality, it is suggested that to the extent current period working capital accruals flow show up as cash flows in the next period, those accruals are of high quality. ERC responds positively to accrual quality o Growth Opportunities: The GN (Good News) or BN (Bad News) in the current earnings may suggest future growth prospects for the firm, and hence a higher ERC. Despite having a large historical cost component, net income can indicate which of the firms projects will remain successful into the future and to what degree, also better profitability usually leads to easier access to capital, especially if the firm is marked as a growth firm o The Similarity of Investor Expectations: Different investors will have different expectations of a firm’s next-period earnings, depending on their prior information and the extent of their abilities to evaluate financial statement information. However, if a certain piece of news unifies investors in their future expected earnings for a firm (i.e., all think will increase, or all think will decrease) the ERC will increase. o The Informativeness of Price: Sometimes the market price of a security itself is partially informative of the future value of a firm, given that it reflects all publically available information. In the BB study we saw that share returns anticipated the GN/BN, in these instances the ERC was less because there was less unanticipated information in the earnings announcement. Despite the fact that large firms are in the news more, it has not been found that firm size is a significant explanatory variable for ERC - Knowing what affects ERC lets us as accountants known what information is more useful for investors, and how to frame the financial statements for maximum usefulness. Higher ERC = more usefulness, however we cannot conclude that the best accounting policy is the one that produces the highest ERC. Accountants will be better off by producing more useful information, but we must ensure that society will be better off as well - Information has characteristics of a Public Good. A public good is a good such that consumption by one person does not destroy it for use by another. Consumption of a Private Good – such as an apple – eliminates its usefulness for other consumers. Financial statements are a public good, as investors can use the information in the annual report without eliminating its usefulness to other investors. - Because accounting information is a public good, most will not consider the cost incurred by society to produce it (i.e., companies raising prices to pay for issuing expensive annual reports). We as accountants must bear this in mind when determining the most ideal accounting policy, and ensure that the cost/benefit trade-off is appropriate Chapter 6 – The Measurement Approach to Decision Usefulness - The Measurement Approach to decision usefulness is an approach to financial reporting under which accountants undertake a responsibility to incorporate current values into the financial statements proper, providing that this can be done with reasonable reliability, thereby recognizing an increased obligation to assist investors to predict firm performance and value - The important question for efficiency is not whether prices reflect fundamental value, but whether they reflect publicly available information - There is evidence that shares are often mispriced relative to their efficient market values, and so the question arises of whether securities markets are truly efficient? - The basic premise of this question is that average investor behaviour may not correspond with the rational decision theory and investment models outlined in Chapter 3. For example, individuals may have Limited Attention. That is, they may not have time, inclination, or ability to process all available information. Then, they will concentrate on information that is readily available, such as the “bottom line,” and ignore in notes and other disclosures - Investors may also be biased in their reaction to information, relative to how they should react according to Bayes’ theorem. For example, there is evidence that individuals are Conservative (not to be confused with conservatism in account – lower of cost or market, ceiling tests, etc) in their reaction to new evidence. Conservative individuals revise their beliefs by less than Bayes theorem implies, otherwise stated, they retain excess weight on their prior beliefs - Psychological theory and evidence also suggests that individuals are often Overconfident – they overestimate the precision of information that they collect themselves, and perhaps by extension underreact to information collected by anyone else. Another individual characteristic from psychology is Representativeness. Here, the individual assigns too much weight to evidence that is consistent with the individual’s impressions of the population from which the evidence is drawn. Then, situations are viewed as unique, when consideration of past history could yield valuable insights - Yet another attribute of many individuals is Self-Attribution Bias, whereby individuals feel that good decision outcomes are due to their abilities, whereas bad outcomes are due to unfortunate realizations of states of nature, hence not their fault - Motivated Reasoning is a somewhat different behavioural characteristic. Here, individuals accept at face value information that is consistent with their preferences (e.g., good news (GN)). However, if information is inconsistent with their preferences (BN), it is received with scepticism, and the individual attempts to discredit it - The study of behavioural-based securities market inefficiencies is called Behavioural Finance - The Prospect Theory provides a behavioural-based alternative to the rational decision theory. According to prospect theory, an investor considering a risky investment (a “prospect”) will separately evaluate prospective gains and losses. This separate evaluation contrasts with decision theory where investors evaluate decisions in terms of their effect on total wealth. Separate evaluation of gains and losses about a reference point is an implication of the psychological concept of Narrow Framing, whereby individuals analyze problems in too isolated a manner, as a way of economizing on the mental effort of decision-making - Disposition Effects describe where an investor holds on to losers and sells winners, and, indeed, may even buy more of a loser security - Ohlson Clean Surplus Theory (FO Model): Provides a framework consistent with the measurement approach, by showing how the market value of the firm can be expressed in terms of fundamental balance sheet and income statement components. The theory assumes ideal conditions in capital markets, including dividend irrelevancy. The clean surplus theory model is also called the residual income model. The model asserts that the fundamental determinant of a firm’s value is its dividend stream, and therefore uses the present value of cash on hand, or cash expected at a date in the future to calculate the expected present value of dividends. The market value of the firm can also be expressed in terms of financial statement variables: At any time t where bv is the net book value of the firm’s assets per the balance sheet and g, is the expected present value of future abnormal earnings, also called goodwill. For this relationship to hold, it is necessary that all items of gain or loss go through the income statement, which is the source of the term “clean surplus” in the theory - There are two other formulae which will yield the same result as the FO model for firm value: o PV of Expected Future Dividends o PV of Expected Future Cash Flows - The FO model represents a special case of unbiased accounting (the measurement approach at its extreme); that is, all assets and liabilities are valued at current value. When accounting is unbiased, and abnormal earnings do not persist, all of firm value appears on the balance sheet - If a firm uses historical cost accounting, or more generally, conservative accounting for its capital assets, FO would call this biased accounting. When accounting is biased, the firm has unrecorded (i.e., self-developed) goodwill (g) - Auditors have faced significant pressure to value assets at historical costs even when their current values were much lower. This has occasionally led to multi-million dollar legal settlements and increased scrutiny on auditors themselves - Another method to increase reported earnings in the past was Gains Trading. Gains Trading (also called “cherry picking”) can be employed when investment portfolios are valued on a cost basis (in the past they mostly were), and when at least some securities have risen in value. Then, the firm can realize a gain by selling securities that have risen in value, while continuing to hold securities that have fallen in value. No loss was typically realized by these latter securities, as they continued to be carried at cost on the grounds that they would be held to maturity - Ceiling Tests are an example of a partial measurement approach. If net future cash flows from an assets are less than book value, the asset is written down to its current value. - Conservative accounting appears to be on the rise based on studies by Basu analyzing various periods, perhaps as a response to various financial scandals - Early voluntary loss disclosure by managers may be an attempt by managers to discourage the lawsuits that usually follow bad news. This early disclosure appeared to have no effect on the number of lawsuits, but did tend to reduce the amounts of the lawsuit settlements - Behavioural theory suggests that help may be supplied by moving some information, such as current values, from financial statement notes into the financial statements proper Chapter 7 – Measurement Applications - The movement of the accounting practice to the measurement approach faces some formidable obstacles: o Concerns over the loss of reliability which will result o Management’s scepticism about Reserve Recognition Accounting (RRA) o Managers, investors, and auditors may prefer conservative accounting to current value accounting in some circumstances (arguments have been made that it contributes to investor decision making, and reduction of auditor liability) - The first method of current value accounting (Value-in-Use) is thought to be the ultimate in relevance, because it represents the PV of the discounted cash flows the asset/liability is expected to generate/lose. However, there is a major qualification. Value-in-Use depends on how the item is used by management, which may change strategically - The IASB has moved to control this by introducing the concept of a Business Model. Under IFRS 9, certain financial assets can be initially valued at value-in-use only if the firm’s business model involves holding the asset to generate cash flows from interest and principal payments. Changes in the business model are expected to be “very infrequent” - The second method of current value accounting is Fair Value, which is described as: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date - The basis of valuation is termed Exit Price, which measures the opportunity cost to the firm of the intended use of its assets and liabilities - In light of the possibility of market incompleteness or a lack of well-working market prices, the FV standards have created a Fair Value Hierarchy: o Level 1: Assets and liabilities for which a reasonably well-working market price exists o Level 2: Assets and liabilities for which a market price can be inferred from the market prices of similar items o Level 3: Assets and liabilities for which a market value cannot be observed or inferred. Then, the firm shall use the best available information about how a market participant holding the asset or liability would value the item - Common longstanding instances of current value-based measurements: o Accounts Receivable and Payable: Current AR (net of allowance for doubtful accounts) and AP are valued at the expected amount of cash to be received or paid. Since the length of time to payment is short, the discount factor is negligible o Cash Flows Fixed by Contract: The Effective Interest Rate is the interest rate on the debt established at time of issuance. By discounting assets and liabilities at this rate, the book value and value-in-use become the same, as long as the firm’s borrowing rate doesn’t change. This is referred to as Amortized Cost Accounting o Lower-of-Cost-or-Market Rule: Traditionally applied to inventories, this is a long- established example of a partial measurement approach. In the name of conservatism, if the market value of these items drops below cost it must be adjusted downwards, if the market value subsequently changes to something higher than cost, then they can be adjusted upwards, but never above cost again o Revaluation Option for Property, Plant, and Equipment: IAS 16 allows a Revaluation Option as an alternative to historical cost; tangible capital assets can be valued at fair value, providing this can be done reliably. Once assets are revalued, fair values must be kept up to date, so as to not differ materially from the FV at the balance sheet date - Financial Instrument: A contract that creates a financial asset of one firm and a financial liability or equity instrument of another firm - IAS 39 classifies financial assets into four categories: o Available-for-Sale: There are non-derivative financial assets that the firm designates upon acquisition as available for sale or that are not classified into the other 3 categories. They are valued at fair value, with most unrealized gains and losses included in other comprehensive income. Upon disposition, unrealized gains and losses are transferred from other comprehensive income to net income o Loans and Receivables: Non-derivative financial assets with fixed or determinable future payments that do not have active market values, such as bank notes. They valued at amortized cost, subject to an impairment test o Held-to-Maturity: There are non-derivative financial assets with fixed or determinable payments that the firm intends to hold to maturity. A portfolio of bonds for example. They are valued at amortized cost, subject to an impairment test similar to loans and receivables o Financial Assets at FV through Profit or Loss: This category includes all derivatives not held for hedging and non-derivative financial assets held for trading, that is, held for the short-term purpose of selling. As the category name suggests, unrealized gains and losses on financial assets in this category are included in net income - This ability to designate gives firms a Fair Value Option, where they can opt to value assets and liabilities at fair value even though it is not required. Once designated under this option, the firm must continue to fair-value the asset/liability in subsequent periods - There is a strong incentive for firms to switch between classes (e.g., switching from held-to- maturity to available-for-sale would result in a bump in net income in most cases). However the IAS 39 provides disincentives to control for this - Mismatch arises when some assets/liabilities are fair-valued but related assets/liabilities are not - Derecognition is the process of an asset being removed from the balance sheet and revenue recognized on the resulting sale. The usual criterion for derecognition is point of sale. However, firms who transfer their accounts and mortgages receivable believe this qualifies as derecognition as well. This is because firms have an incentive to derecognize, since this can improve their leverage ratios - Derivatives can be difficult to value, traditionally the Black-Scholes option pricing formula has been used - With regard to Goodwill, there is a difference between purchased Goodwill and self-developed Goodwill. When one firm acquires another in a business combination, the difference between the net amount of the fair values of assets and liabilities purchased and the price paid by the acquiring company is deemed to be Goodwill. On the other hand, no readily identifiable transactions exist to determine Goodwill. Consequently, R&D costs which may generate Goodwill are written off as incurred mostly. Any Goodwill that develops from these costs appears as abnormal earnings in subsequent income statements - These are several reasons why firms manage their own firm-specific risk and are required to disclose firm specific risks and how they are managed, despite the fact that investors can manage this themselves via diversification: o CAPM does not include for estimation risk. Reporting on the firm’s risk management strategies may reduce investor concerns about estimation risk resulting from adverse selection o Firms that are planning large capital expenditure may wish to ensure cash is available when needed o Managers may use derivatives to speculate. This is a form of risk management that increase risk rather than decreases it o Managers whose compensation is based on earnings may use derivatives to reduce the volatility of their compensation - Two quantitative measurement techniques to value risk reporting are Sensitivity Analysis and Value at Risk. Sensitivity analysis shows the impact on earnings, cash flows, or fair values of financial instruments, resulting from changes in relevant commodity prices, interest rates, and foreign exchange rates. Value at Risk is the loss in earnings, cash flows, or fair values resulting from future price changes sufficiently large that they have a specified low probability of occurring Chapter 8 – Economic Consequences and Positive Accounting Theory - The interests of management must be incorporated into accounting standards through due process, or, equivalently, through a process of Conflict Resolution, rather than deduced from basic principles as it is for investors - Economic Consequences: A concept that assets that, despite the implications of efficient securities market theory, accounting policy choice can affect firm value. Essentially it is the notion that firm’s accounting policies, and changes in policies, matter - Even accounting policies which do not affect actual cash flow (e.g., changing from declining balance depreciation to straight-line) will matter because they are going to affect net income, which is an economic consequence we must consider - The presence of economic consequences has raised the question of why they exist; the answer begins with Positive Accounting Theory. This theory is based on the contracts that firms enter into (typically management compensation and debt contracts). These contracts are frequently based on financial accounting variables such as net income or measures of liquidity. It follows that management may choose accounting policies so as to maximize the firm’s interests, or its own interests relative to these contracts. Therefore, Positive Accounting Theory attempts to predict what accounting policies managers will choose in order to do this - Employee Stock Options (ESOs) are an area where economic consequences have been particularly apparent - Until relatively recently, accounting for ESOs in the United States was based on the 1972 Opinion 25 of the Accounting Principles Board (APB 25). This required firms issuing fixed ESOs to record an expense equal to the intrinsic value of the option (the difference between the market value of the option on the grant date and the exercise/strike price of the option. However, most firms simply set the exercise price to equal the grant date market price, making the intrinsic value zero. As a result, no expense for ESO compensation was recorded - The policy above led to understatement of firm’s compensation costs and overstated net income. It also contributed to a lack of earnings comparability, as different firms have different proportions of options in their compensation packages - One of the reasons FV accounting was not used in the recording of options was the difficulty establishing its value. This was made much simpler after the development of the Black-Sholes model. However, the Black-Sholes model was not perfect. The model assumes that options can be freely traded, whereas ESOs are likely non-transferrable and cannot be exercised until the vesting date. In addition, the model assumes that the option cannot be exercised prior to expiry (a European Option), whereas ESOs are American Options (can be exercised prior to expiry). Nevertheless, it was felt by many that the Black-Scholes model still provided a reasonable basis for estimation of ESO fair value. Thus, in 1993, proposed standards were changed to require firms to record co
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