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BU457 Final: Exam Review Notes

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Wilfrid Laurier University
Bixia Xu

Exam Review Notes Reserve Recognition Accounting • On the surface, the PV information conforms quite closely to the theoretical present value model under certainty • However, serious problems of estimation is revealed because oil and gas companies do not operate under the ideal conditions assumed by the theoretical model • As a result, reserve information lose reliability, as evidenced by need for substantial annual revisions and possible bias, as it gains relevance • It ems necessary to trade off these two desirable information qualities Accounting Under Ideal Conditions • Instead of dwelling on questions of existence of net income, accountants have turned their efforts to making financial statements more useful Portfolio Risk • When transactions costs are not ignored, a risk-averse investor’s optimal investment decision is to buy relatively few securities, rather than the market portfolio • In this way, most of the benefits of diversification can be attained, at reasonable cost • Information about expected returns and betas is useful to investors, as it enables them to assess the expected returns and riskiness of the portfolios and choose one that gives them their preferred risk-return tradeoff Decision Usefulness • Single-person decision theory and its specialization to the portfolio investment decision provide an understanding of the needs of rational, risk- averse investors • Such investors need information to help them assess securities’ expected returns and the riskiness of these returns • Financial statements are an important and cost-effective source of information for investors, even though they do not report directly on future investment payoffs • They provide an information system that can help investors to predict future firm performance, which, in turn, predicts future investment returns • To enhance this predictive role, accountants need to find the most useful tradeoff between relevance and reliability Securities Market Efficiency • Markets being efficient or not efficient is the wrong question. It’s about the extent of efficiency. • Securities markets are not fully efficient, based largely on the development of bubbles and the continued existence of anomalies • Arguments can be made that they are reasonably close, o Evidence of sophisticated response to accounting information described in Chapter 5 suggest considerable efficiency o Experimental studies supporting non-rational investor behaviour using student subjects leave open the question of whether more experienced investors would behave in a similar manner o Increasing theory and evidence that limits to arbitrage, such as cost and risk, make is difficult for investors to actually earn riskless profits by taking advantage of anomalies. We can hardly expect the market to be efficient with respect to more information than it is cost effective to exploit o With respect to the bubble leading up to the 2008 market meltdown, there is some evidence that the market tried to adjust for off-balance sheet risk. However, available information may not have been sufficient to fully diagnose this risk. For example, complex financial instruments such as the asset-backed securities lacked transparency. Consequently, the under reaction to risk that contributed to the bubble was not necessarily due to non-rational investors since risk was masked by high ratings from ratings agencies and inadequate reporting of off-balance sheet obligations o Standard s
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