CGA-CANADA ACCOUNTING THEORY 1 EXAMINATION June 2002 Marks

30

Time: 3 Hours
Question 1 Select the best answer for each of the following unrelated items. Answer each of these items in your examination booklet by giving the number of your choice. For example, if (1) is the best answer for item (a), write (a)(1) in your examination booklet. If more than one answer is given for an item, that item will not be marked. Incorrect answers will be marked as zero. No account will be taken of any explanations you offer. Note:
2 marks each

a.

Which of the following is an incentive for managers to produce information about their firms even when not required to do so by regulations? 1) 2) 3) 4) Signalling to the securities market The frequent breakdown of the disclosure principle The lower cost of capital Insider trading regulations

b. In the United States, accounting rules for translating financial statements of foreign subsidiaries to U.S. dollars were set out in SFAS 8. Later, SFAS 8 was dropped and was replaced by SFAS 52. Which of the following applies to SFAS 8? 1) The accounting treatment of non-monetary assets is not consistent with the purchasing power parity (PPP) theory of exchange rate determination. 2) The accounting treatment of non-monetary liabilities is not consistent with the interest rate parity (IRP) theory of exchange rate determination. 3) Neither the accounting treatment of non-monetary assets nor that of non-monetary liabilities is consistent with purchasing power parity theory or interest rate parity theory of exchange rate determination. 4) The accounting treatment of non-monetary assets and non-monetary liabilities under SFAS 8 is consistent with the purchasing power parity theory and interest rate parity theory of exchange rate determination, respectively. c. Managerial compensation contracts for large, publicly traded firms typically depend on both net income and share price performance. When will the proportion of total compensation that is based on net income be highest in such contracts? 1) 2) 3) 4) When net income is highly sensitive to manager effort When the firm is growing rapidly When the correlation between share return and return on equity is high When the firm is heavily engaged in R&D

d. Positive accounting theory (PAT) has often been used in accounting research. What is the objective of PAT? 1) It develops criteria to be used by standard setters while setting new accounting standards. 2) It is concerned with predicting firms accounting policy choices and how firms will respond to mandatory accounting changes. 3) It helps management to increase net income. 4) It develops ways for management to increase share prices. Continued...
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e.

Which of the following statements is a consequence of contract rigidity? 1) 2) 3) 4) Unforeseen realizations of states of nature impose costs on firms and managers. It is less costly to change accounting standards than to change the contract. Contract rigidity implies incomplete contracts. Contract rigidity supports basing manager compensation on reported net income.

f.

In 1997, SFAS 130, Comprehensive Income, was issued by the FASB. Where should comprehensive income be reported, according to SFAS 130? 1) 2) 3) 4) In the assets section of the balance sheet In the liabilities section of the balance sheet In a separate statement of changes in the shareholders equity section of the balance sheet In the cash flow statement as a financing item

g. Which of the following actions is most effective in increasing the main diagonal probabilities of the information system? 1) 2) 3) 4) Choosing accounting policies with high relevance Increasing use of fair value accounting in the financial statements proper Voluntarily issuing future-oriented financial information (FOFI) Adopting reserve recognition accounting in the financial statements proper

h. Net income from oil and gas properties of a firm prepared under historical-cost-based accounting often differs from net income calculated under the alternative format using reserve recognition accounting (RRA) data. What is the reason for this difference? 1) Declines in reserves are captured more quickly under RRA than under the historical-cost-based method. 2) RRA uses a mandated 10% discount factor for all firms. 3) The stock market is efficient. 4) RRA-based net income is more relevant than historical-cost-based net income. i. Which of the following statements best characterizes extraordinary items? 1) Extraordinary items are not expected to recur frequently but they may typify normal business activities. 2) Extraordinary items depend on decisions or determinations by management. 3) Extraordinary items are likely to have lower persistence than operating items. 4) Extraordinary items are not included in net income. j. The market model is defined as follows:
R jt = j + j R mt + jt

Equation (1)

Where R jt = return on share j for time period t; j and j are coefficients; R mt = return on the market portfolio for time period t; and jt = abnormal returns. In equation (1), what does the beginning of period expected return equal? 1)
j + jt j + R mt j + j R mt

2) j R mt 3) 4)

Continued...
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k. Which of the following statements best describes the term accretion of discount? 1) 2) 3) 4) l. Expected net income Actual net income under ideal conditions of uncertainty The expected present value of future cash receipts from an asset Expected present value of future cash flows of the firm

A logical inconsistency related to market efficiency is as follows: If prices fully reflect available information, there is no motivation for investors to acquire information; hence, prices will not fully reflect available information. How is this logical inconsistency resolved? 1) Noise or liquidity traders in the market make buy/sell decisions that are not based on a rational evaluation of relevant information. As a result, market prices are not fully informative. 2) Many investors stay out of the market because they do not view it as a level playing field. 3) Adverse selection in the market prevents market prices from fully reflecting available information. 4) Moral hazard prevents market prices from being fully informative.

m. Which of the following statements is most consistent with the concept of an efficient securities market anomaly? 1) 2) 3) 4) Post-announcement drift can be explained as a reward for holding riskier-than-average stocks. Beta is dead. An efficient securities market anomaly will disappear over time. Abnormal securities returns persist for some time following an informative event.

n. Sometimes managers of firms have incentives to smooth income over time. Why would managers want to smooth income? 1) Income-smoothing leads to tax savings. 2) Smoothed income reduces income volatility and reduces the probability of debt covenant violations. 3) Income-smoothing is not considered earnings management. 4) Firms that smooth income have more efficient managerial compensation plans. o. Why is fair value accounting important to accountants even though ideal conditions do not hold in practice? 1) 2) 3) 4) 12 Because the closer the accountant can reliably measure present value, the better Because many implementations of fair value accounting are based on market value Because fair values are more decision useful than values based on historical cost Because true net income does not exist except under ideal conditions

Question 2 Many managerial compensation contracts require managers to bear risk with respect to their compensation. Required 4 a. If risk is introduced into managerial compensation contracts by basing compensation on net income and/or share price performance, what will the effect be on the following? Explain. i) Adverse selection ii) Moral hazard 4 b. State two reasons why it is not advisable to introduce too much risk into managerial compensation contracts. c. Describe two ways by which a managers risk can be reduced while maintaining appropriate incentives.
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Question 3 The article Martin Expresses Concern Over Illegal Trades appeared in The Globe and Mail on October 19, 1999 (see Exhibit 3-1). The article suggests that insider trading is a problem in Canada and that rules against such trading need greater enforcement. Required 3 a. Explain why Finance Minister Paul Martin is concerned that securities markets work properly in Canada.

4 4

b. Explain why, according to Mr. Martin, insider trading undermines the countrys capital markets. c. What well-known problem of information asymmetry underlies insider trading? Explain the extent to which financial reporting can reduce the inside information that leads to insider trading.

EXHIBIT 3-1 Martin Expresses Concern Over Illegal Trades Says irregularities undermine Canadas capital markets Finance Minister Paul Martin is concerned about the reports of stock trading irregularities on the exchanges, saying the problem undermines the countrys capital markets. A Globe and Mail investigation into illegal insider trading released yesterday suggests the practice is widespread but regulators are doing little to stop it. The confidence in the system is very much dependent on its integrity and obviously anything that would touch that integrity is of concern to us, as I know it is to the provincial government whose jurisdiction this is in, Mr. Martin said. He said the provinces should proceed with plans to form a national regulatory system. What we want to do is see the provinces further their efforts toward the virtual commission that theyre all working at. We have said that if we can be of any help, we are certainly prepared to be there. Despite its woeful record of bringing offenders to account, Canadas leading securities regulator insisted yesterday that combating illegal insider trading is one of its top priorities. Illegal insider trading is a concern at the OSC [Ontario Securities Commission] and has always been a concern, said Frank Switzer, responding to The Globe and Mails investigation. Since we have moved to self-funding, we have increased our resources in the enforcement branch and want to look at these things. Last week, the OSC charged Corel Corp. chief executive officer Michael Cowpland with illegal insider trading. The regulator alleges the flamboyant businessman sold nearly 25 per cent of his Corel holdings after he learned the company would fall short of its forecast sales for the third quarter of fiscal 1997. That information had not yet been made public. But only one person has ever spent time in jail for illegal insider trading in Canada, and only one person has ever pleaded guilty to it. As well, there have been only a handful of cash settlements in the OSCs history. OSC chairman David Brown declined to be interviewed for Mondays story and could not be reached for comment yesterday. Continued...
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EXHIBIT 3-1 (Continued) Craig Dunbar, assistant professor of finance at the University of Western Ontarios Richard Ivey School of Business in London, Ont., said illegal insider trading is a serious issue for regulators. Do insiders benefit? Absolutely, he said. The issues of the level playing field and the perception in the market are very real. The analysis [of the Globe study] was clearly on track. It is so common to see prices go way up before a deal is announced. Source: Susanne Craig and Shawn McCarthy, Martin Expresses Concern Over Illegal Trades, The Globe and Mail, October 19, 1999, p. B15. Reprinted with the permission of Globe Interactive.

Question 4 This question is based on the article Daimler Rescue May Lead to Loss, which appeared in The Globe and Mail on February 26, 2001 (see Exhibit 4-1). Required 2 a. Based on the information provided in the article, compute DaimlerChrysler AGs expected income (loss) after one-time charges for the year 2001.

b. Explain why it is advisable to report the amount of operating income and the amount of one-time charges separately (as the article has done). Relate your answer to the notion of earnings response coefficients (ERCs) of the three types of earnings (or earnings components), as propounded by Ramkrishnan and Thomas (1991). c. Identify and briefly describe the signal that adds credibility to Mr. Schrempps statement about future earnings.

EXHIBIT 4-1 Daimler Rescue May Lead to Loss Chrysler, Mitsubishi drag on operations Enormous restructuring costs at its U.S. and Japanese operations are likely to push DaimlerChrysler AGs operating profit into the red this year, a source familiar with the situation said. The source said operating profit is likely to fall sharply during 2001 as a result of losses at Chrysler and Mitsubishi Motors Corp. Counting one-time charges of as much as 3.5 billion euros ($3.22-billion U.S.) to restructure the pair of companies, the operating result could possibly end up as a small loss. DaimlerChrysler chairman Juergen Schrempp is to provide a detailed forecast for the company and its Chrysler unit at a news conference in Stuttgart this morning. The source said the chairman wants to deliver a bold message to financial markets about steps he is taking to turn around the companys overseas operations, and then offer an aggressive timetable for a return to solid profit. The source wouldnt give exact forecasts.

Continued...
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EXHIBIT 4-1 (Continued) The source indicated this years operating profit for DaimlerChrysler, before restructuring charges, could be less than 2 billion euros. According to a report in Germanys Die Welt newspaper, Mr. Schrempp will say today that operating profit, excluding one-time items, should climb to between 5.5 billion and 6.5 billion euros in 2002, and to between 8.5 billion and 9.5 billion euros in 2003. DaimlerChrysler wouldnt comment on any of the projections. Mr. Schrempp also is to offer an optimistic outlook on Chrysler, DaimlerChryslers struggling U.S. arm and the main reason for the profit and sales slowdown this year, according to the source. Mr. Schrempp is expected to say Chrysler will likely report an operating loss of between $1.99-billion and $2.35-billion (U.S.). But in two years, operating profit without one-time items will climb to between $1.18-billion and $2.26-billion, the newspaper said. People familiar with the situation say the Die Welt report paints an accurate picture, but they wouldnt confirm specific figures. While the core of the old Daimler-Benz AG, Mercedes-Benz, remains healthy, the groups far-flung empire has become a near-disastrous problem. Chrysler is believed to have lost $1.7-billion in the second half of last year, and Mitsubishi, the Japanese auto maker in which DaimlerChrysler took a 34-per-cent stake less than a year ago, is deeply in debt. Separately, a source knowledgeable about DaimlerChrysler said it will spend nearly 3.5 billion euros this year to fix troubled car operations in the United States and Japan. DaimlerChrysler, this source said, will announce this morning that it will take a charge this year of nearly 3 billion euros to overhaul its ailing Chrysler operation, the high end of what financial markets had expected. The person also said DaimlerChrysler will contribute somewhat less than 500 million euros to help the makeover at Mitsubishi. The Japanese auto maker would pay the remaining two-thirds of its own repair bill. In addition to the auto business, DaimlerChrysler is expected to say that it will take a charge on overhauling its U.S. truck operation, Freightliner. One person said the company expected to pay much less than 500 million euros but wouldnt be more specific. The restructuring charges are to cover the cost of laying off tens of thousands of workers in the United States and Japan, shutting factories and streamlining production and development. Any forecasts from Mr. Schrempp will amount to a high-stakes gamble to win over financial markets. Forecasting steeply higher profit might be popular with investors, but he will have to deliver. Already under pressure for inflating expectations about the merger of Daimler-Benz and Chrysler Corp., the chairman may not be able to withstand the outcry that could follow failing to meet targets again. Company insiders say major investors such as Deutsche Bank AG have given him no more than 12 months to prove that his plans for turning the company around are working. Source: Scott Miller and Jeffrey Ball, Daimler Rescue May Lead to Loss, The Globe and Mail, February 26, 2001, pp. B1 and B4. Reprinted with the permission of Globe Interactive.

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Question 5 This question is based on the article RBCs Coup Spurs Disclosure Row, which was published in The Globe and Mail on February 26, 2001 (see Exhibit 5-1). The article discusses the impact of new U.S. fair disclosure rules on firms disclosure policies. These policies prohibit firms from providing preferential access to company information to only selected individuals. Required 3 4 a. Which theory of regulation are these disclosure rules consistent with? Briefly explain.

b. What are the effects of the new disclosure policy (that is, same disclosures to all) on moral hazard and adverse selection? Briefly explain. c. According to the article, some analysts feel that the operation of the new disclosure policy would lead to more divergent earnings forecasts. Do you agree with these analysts? Explain your reasoning. In your answer, indicate the likely: i) short-term trends ii) long-term trends EXHIBIT 5-1 RBCs Coup Spurs Disclosure Row John Wilson thought he had a Bay Street coup when he drove to the Brampton, Ont.-based headquarters of Nortel Networks Corp. two weeks ago to Webcast an exclusive interview with its chief executive officer, John Roth. Instead, Mr. Wilson, an analyst with RBC Dominion Securities Inc., skidded into a massive disclosure controversy that has shaken investor faith in Nortel, triggered a regulatory review and unleashed a flood of law suits. While Nortel is the target of the fury, Bay Street is one of the biggest casualties. We were to a degree inadvertently caught in the middle, Gordon Nixon, chief executive officer of RBC Dominion, told reporters in Vancouver, following the annual meeting Friday of its parent, Royal Bank of Canada. RBC Dominions interview with Mr. Roth on Feb. 12 was designed to combat the troubling reality that public companies are increasingly bypassing brokerage analysts to communicate directly with shareholders. Thanks to tough new disclosure rules and such technology advances as the Internet, analysts are losing their once-privileged role as the primary source of corporate information for investors. RBC Dominion had hoped to win back investors by broadcasting the live interview with Mr. Roth over the Internet exclusively to its brokers and clients. Not only was the Webcast the first of its kind for RBC Dominion, but it featured one of North Americas most-sought-after executives. Initially, Mr. Roth didnt disappoint the few hundred listeners who logged on to RBC Dominions 15-minute Webcast. He telegraphed Nortels concerns that clients were rapidly putting the brakes on equipment orders. But when Nortel went public three days later with the shattering news that it was slashing its growth forecast, investors began screaming foul over how the telecommunications giant disclosed the bad news.

Continued...
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EXHIBIT 5-1 (Continued) Securities regulators and lawyers will likely spend months debating whether Mr. Roth unfairly gave RBC Dominions clients a heads up about the bad news on the Webcast. In the meantime, one thing is certain: Few major public companies would ever again risk giving brokers such exclusive access to their executives comments. Those that do will be so cautious about tripping over tough new U.S. fair disclosure rules, known as Regulation FD, that it is doubtful anything material will be discussed. You have to talk to everybody now about anything, Toronto-based investor relations consultant John Lute said. The move to fuller disclosure means that individual investors now have access to most corporate conference calls and earnings forecasts that were once limited to select analysts and shareholders. While the trend has levelled the field for small investors, it has greatly eroded the exclusive information that brokerage firms traditionally delivered to their clients. It will be more difficult for brokerage houses going forward, said senior vice-president Morgan McCague at Ontario Teachers Pension Plan Board. An awful lot of Bay Street and Wall Street firms are actually going to have to go out and do analysis rather than regurgitate corporate information. Without special corporate access, investment experts predicted that earnings forecasts by analysts at various brokerages will likely be more divergent and corporate earnings surprises more common. Companies are not going to be able to manage their relationship with the Street anymore, said Peter Dawkins, a managing director and head of equity research at CIBC World Markets Inc. There will be more wild-eyed estimates Access to corporate executives is increasingly proving to be a challenge. Most brokerage analysts say companies stick to a tight script of previously disclosed information when their executives are interviewed, and their availability is limited. Inco Ltd., for example, has traditionally met investors and major shareholders in Toronto and New York every February to discuss its annual results. This year for the first time, the mining companys executives met only in Toronto with analysts and shareholders and it simultaneously Webcast the widely advertised session to ensure all shareholders had equal access. Were very sensitive to the need to disclose information appropriately, said Alan Stubbs, a vice-president at Toronto-based Inco. One of the biggest casualties of the new disclosure regime is earnings guidance. For years, brokerage analysts have taken their earnings forecasts to company officials for private guidance on the accuracy of their outlooks. To avoid unfair disclosure, public companies are increasingly avoiding the so-called whisper forecasts. CIBCs Mr. Dawkins said he welcomes the trend because it will weed out the weaker analysts who mostly base their research on information from the companies they follow. Investors are still going to look for someone to analyze all the facts and reach a conclusion. The analysts who are faking it are in trouble, he said. Source: Jacquie McNish, RBCs Coup Spurs Disclosure Row, The Globe and Mail, February 26, 2001, pp. B1 and B4. Reprinted with the permission of Globe Interactive.

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Question 6 Kurt, who owns and operates a small successful retail store, has not had a holiday for 3 years. He decides to take an extensive 1-year trip around the world, and is negotiating with Lynne to operate the store in his absence. The stores earnings, before deducting the managers salary and other compensation, are highly dependent on how hard the manager works, as per the following table: a1 : Work Hard Payoff x1: High earnings x2: Low earnings $260 $ 80 Probability 0.8 0.2 Payoff $260 $ 80 a2 : Shirk Probability 0.1 0.9

Lynne, like most people, is risk averse and effort averse. Her utility for money is equal to the square root of the amount of money received. If she works hard, her effort disutility is 2. If she shirks, her effort disutility is 1.5. Lynne tells Kurt that she is willing to accept the manager position but that she must receive at least an expected utility of 3.49, or she would be better off working somewhere else. After some calculations, Kurt offers Lynne a salary of $20 plus 5% of the store earnings (after deducting the $20 salary). Required 6 4 a. Will Lynne likely accept Kurts contract offer? Show your calculations to support your answer.

b. Kurt insists that if he hires Lynne, the stores annual earnings must be audited by a professional accountant. Explain why Kurt would require this audit. c. Assume that Kurt hires Lynne under the contract proposed, that is, $20 salary plus 5% of profits after salary. Shortly after Kurt leaves, a new accounting standard comes into effect, which requires that estimated customer liability be accrued. This lowers the high earnings to $200 and the low earnings to $70 in the table above. The payoff probabilities are unaffected. What will Lynne likely do now? Show your calculations to support your answer.

Note:
Calculate values to 2 decimal places.

12

Question 7 XYZ Ltd. operates under ideal conditions. On January 1, 2000, it purchased a capital asset with a useful life of 3 years, at the end of which time the asset will be worthless. The capital asset will generate a single cash flow of $3,993 on December 31, 2002. The purchase is financed partly by an issue of common shares and partly by an issue of a non-interest bearing note maturing on December 31, 2002 with a maturity value of $1,500. The risk-free interest rate in the economy is 10%. Required 3 3 3 3 a. Prepare an income statement for XYZ Ltd. for the year ended December 31, 2000.

b. Prepare a balance sheet for XYZ Ltd. at December 31, 2000. c. Calculate the expected net income for the year ended December 31, 2001.

d. Prepare a balance sheet for XYZ Ltd. as at December 31, 2001.

END OF EXAMINATION 100

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CGA-CANADA ACCOUNTING THEORY 1 EXAMINATION June 2002 SUGGESTED SOLUTIONS Marks

Time: 3 Hours

Sources/Explanations: a. 3) Topic 9.2 (Level 1) If managers voluntarily release information, the capital market will reward their firms with a lower cost of capital, according to the models of Merton (1987) and Diamond and Verrecchia (1991). These predictions are supported by the empirical results of Botosan (1997). Answer 1) is incorrect because signalling is a vehicle for those managers who desire to voluntarily release information but it is not in itself an incentive. Answer 2) is incorrect because failure of the disclosure principle works against voluntary information release, not for it. Answer 4) is incorrect because insider trading regulations discourage managers from using inside information for their private advantage but do not necessarily encourage them to release the information. b. 4) Topic 6.2 (Level 2) Answer 1) is wrong because accounting for non-monetary assets is consistent with purchasing power parity (PPP) theory. If foreign currency weakens, the loss in value of foreign assets is offset by an increase in nominal foreign cash flow arising from inflation. This offset is consistent with the use of historical exchange rates for non-monetary assets under SFAS 8. Answer 2) is wrong because interest rate parity (IRP) theory makes no direct connection between price levels in the foreign economy and the exchange rate. Thus, the consistency of the accounting treatment for non-monetary items with IRP theory cannot be determined. Answer 3) is wrong because it subsumes answer 2). c. 1) Topic 8.3 (Level 1) Firms will seek the most efficient contracts, according to the efficient contracting version of PAT. The higher the correlation between net income and effort, the more efficient the contract. The other three answers favour a higher proportion of share price performance in the contract. d. 2) Topic 6.7 (Level 1) Answer 1) refers to a normative theory, which PAT is not. The other answers are incorrect. e. 1) Topic 7.4 (Level 1) Since it is impossible to foresee all contingencies that may occur over the life of most contracts, unforeseen realizations of states of nature may occur. Since signed contracts are rigid, it is usually difficult or impossible to work around the unforeseen realization. Then, the firm and its manager must bear any resulting costs. Answer 2) is unlikely. Once accounting standards are in place, they will not be changed to satisfy contracting parties. Such parties must make their views known during the due process leading up to the standard. Answer 3) is incorrect because incomplete contracts are a consequence of the impossibility of foreseeing all possible states of nature, not of contract rigidity. Answer 4) is incorrect because it is the moral hazard problem that supports basing manager compensation on net income, not contract rigidity. Continued...
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f.

3) Topic 10.4 (Level 1) The other answers are incorrect. Comprehensive income is neither an asset nor a liability nor a financing item.

g. 3) Topic 2.2 (Level 1) FOFI is high in relevance since it involves a direct prediction of future firm performance, and this is the essence of relevance. Furthermore, steps are taken in FOFI to retain as much reliability as possible, such as short forecast horizon, auditor involvement, and easy subsequent comparison with actual results. In addition, FOFI has signalling properties since it is voluntary. That is, the fact that a firm is willing to issue a FOFI forecast reveals some inside information to the market beyond the information in the forecast itself. For all of these reasons, the ability of financial statement information to predict future firm performance is enhanced by FOFI, that is, the main diagonal probabilities of the information are increased. Answer 1) is incorrect because high relevance is accompanied by low reliability, so that it is not clear that the main diagonal probabilities are increased. Answer 2) is incorrect for the same reason. It is not necessarily the case that fair value accounting increases the main diagonal probabilities. This will only happen if the increased relevance is not outweighed by lower reliability. Again, answer 4) is incorrect because RRA seems to be quite low in reliability. h. 1) Topic 1.4 (Level 1) RRA net income captures the entire impact of change in present values of reserves in one year, while historical cost net income will capture the changes only when sales are affected because of the change. The intuition explained in answer 1) applies whatever discount rate is used by the firm. Answer 3) is inconsequential. Answer 4) is the effect of answer 1), not the reason for the difference. i. 3) Topic 4.4 (Level 2) Since extraordinary items are not expected to recur frequently, they have low persistence by definition. Answer 1) is incorrect because extraordinary items, as defined in CICA Handbook, do not typify normal business activities. Answer 2) is incorrect for a similar reason. To be extraordinary, an item must not depend on decisions or determinations by management. If it does so depend, it is included in operations, not extraordinary items. Answer 4) is incorrect because net income includes both operating and extraordinary items. j. 4) Topic 3.2 (Level 1)

k. 1) Topic 1.2 (Level 1) This is the definition of accretion of discount. Answer 2) is incorrect because there can be abnormal earnings under ideal conditions of uncertainty. This happens when the state realization does not equal its expected value and, as a result, expected and actual net incomes are unequal. Answer 3) is incorrect by definition this is simply not what accretion of discount is. The same comment applies to answer 4). l. 1) Topic 3.5 (Level 2) The adverse selection and moral hazard issues raised in the other answers are not pertinent.

Continued...
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m. 4) Topic 3.3 (Level 2) Under efficient securities market theory, the information content of an information event will be very quickly reflected in share price, so that resulting abnormal returns will dissipate almost immediately. Evidence that abnormal returns do not dissipate quickly thus constitutes an anomaly. Answer 1) is incorrect because, while risk has been advanced as a possible explanation of efficient securities markets anomalies, the authors of the various anomaly studies considered this possibility and concluded that risk was not driving their results. Answer 2) is incorrect because even if beta is dead, this does not contradict efficient securities market theory. Instead, it means that investors look to some other measures of firm risk than beta. Regardless, it is debatable whether beta is or is not dead. Answer 3) is incorrect because if an anomaly disappears, this is evidence of securities market efficiency, not of inefficiency. n. 2) Topic 8.6 (Level 1) Answer 3) is wrong. Other answers are not pertinent. o. 1) Topic 6.1 (Level 1) Present value is a fundamental determinant of fair value, and provides the utmost in relevance. Thus, given sufficient reliability, asset and liability valuations that come close to present value are decision useful to investors. Since investors are a major constituency of financial statement users, decision usefulness is important to accountants. Answers 2) and 4) do not answer why fair value accounting is important. Answer 3) is incorrect because fair values will not be decision useful if the reliability lost outweighs the relevance gained. 12 4 Question 2 Source: Topic 8.3 (Level 1) a. i) There is no effect on adverse selection as a result of including risk in management compensation contracts. Adverse selection relates to use of inside information for the insiders own advantage, not to manager compensation.

ii) Moral hazard refers to the two action choices of managers work hard or shirk. Since managers efforts are not observable, in order to motivate the managers towards greater effort levels, managerial compensation plans should include payoff measures such as net income and/or share price performance. Since payoff is uncertain, risk is introduced into compensation plans, thus motivating managers to make greater effort to increase the payoff, thereby reducing moral hazard. 4 b. One reason is that managers cannot diversify their compensation risk by actions such as working for many firms. If managers are risk averse, increasing their risk might cause their utility to become less than their reservation utility. This may cause a manager to resign. A second reason is that risk-averse managers will trade off risk with expected returns. The more risk managers have, the greater their expected compensation must be if they have to attain their reservation utility. This will impose a high cost on the firm and reduce net income. A third reason is that managers may take excessive risks on behalf of the firm if the compensation has little downside risk (for example, stock options). Note:
Any two reasons, if adequately justified, are sufficient for full marks.

Continued...
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c.

There are many ways to reduce compensation risk: i) The bogey of a bonus plan reduces compensation risk for the manager. This implies that if net income is low (less that the bogey), the manager does not get a bonus but is not penalized (for example, by a fine).

ii) A compensation committee of the board of directors might consider whether exceptional circumstances, not under the control of the manager, led to the firms lower income. The committee could thus adjust bonuses. This would reduce compensation risk. iii) Managerial risk would be reduced if the firm adopted relative performance evaluation, in which bonuses are based on a firms performance relative to that of other firms in the industry. This would filter out economy-wide or industry-wide factors over which managers have no control. Note:
Two valid methods are sufficient for full marks.

11 3

Question 3 a. Source: Topic 3.7 (Level 2) In a capitalist economy, it is capital markets that direct (scarce) investment capital to competing needs. For this capital investment to go to the most productive projects, it is important that firms with highly productive capital projects have share prices that reflect this high productivity, and vice versa. Then, highly productive firms with high share prices enjoy low costs of capital, which encourages them to invest. Firms with low productivity, low share prices, and high costs of capital are also discouraged from investing.

b. Source: Topic 3.6 (Level 1) Mr. Martin says that insider trading undermines securities markets for two reasons. First, the more inside information there is, relative to outside information, the lower is the ability of the efficient market to properly value firms shares so as to reflect their high or low productivity. This causes misallocation of scarce investment capital in the economy. Second, insider trading causes investors to realize that the securities market is not a level playing field. This realization can cause them to withdraw from the market or, at least, create a lemons problem. Either way, the market price of all shares is reduced. Again, the result is misallocation of scarce capital in the economy, since firms with high productivity capital projects are discouraged from raising share capital to finance them. Note:
Either reason is sufficient for full marks if well explained.

c.

Source: Topic 3.7 (Level 2) The adverse selection problem underlies insider trading. By means of full disclosure, including notes to the financial statements and supplementary information, financial reporting can reduce the problem of insider trading by moving as much information as possible from inside to outside the firm. Such disclosure must be credible if investors are to find it useful. However, financial statements gain credibility due to penalties for violation of disclosure standards and requirements for audits. However, since financial reporting is costly, some inside information will not always be disclosed. In effect, financial reporting can reduce the insider-trading problem but cannot eliminate it completely. Note:
Answers that mention specific reporting policies, such as MD&A, FOFI, notes to the financial statements, and fair values, may also be acceptable. For full marks, an answer should state that, because of disclosure costs, financial reporting cannot completely eliminate inside information.

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Question 4 Source: Topic 4.3 (Level 1) a. DaimlerChryslers income before restructuring charges for 2001 is about 2 billion euros. The restructuring charges are likely to be 3.5 billion euros. Thus, the expected loss after one-time charges is about 1.5 billion euros. Note:
Adding 500 million euros to fix Freightliners truck operations, increasing the expected loss to 2 billion euros, is also acceptable.

b. Ramkrishnan and Thomas (R and T) distinguish three components of earnings that have different persistence, namely, permanent, transitory, and price-irrelevant components. The persistence values of these three component of earnings are 1 + 1 , 1, and 0, respectively, according to R and T. Rt Operating income is likely to have more permanent components than do one-time restructuring charges, which have more low-persistence components. Thus, operating income and one-time charges have different earnings response coefficients (ERCs) as well because persistence from higher-quality earnings is positively related to ERCs. Reporting operating income and one-time charges separately helps investors form their own estimates of a companys earnings persistence, which is useful for making investment decisions. c. Voluntary forecasts about the companys difficulties add credibility to Mr. Schrempps statement. By making such an announcement, he voluntarily puts his forecasts under the gun. The voluntary forecast is the signal.

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Question 5 a. Source: Topic 10.1 (Level 1) The article states that disclosure policies prohibiting selective access to company information levels the playing field for small investors who were at an informational disadvantage prior to the passage of these regulations. These regulations are consistent with the public interest theory because their implementation is an attempt to correct a perceived market failure and is expected to benefit society as a whole.

b. Source: Topic 3.6 (Level 1) This disclosure policy is not likely to have an effect on moral hazard. This disclosure policy is likely to reduce adverse selection in the market. As stated earlier, this policy will level the playing field for smaller investors and will correct the informational disadvantage under which small investors had to operate previously.

c.

Source: Topic 3.1 (Level 1) In the short term, earnings forecasts would be more divergent because different analysts have varying levels of research skills. Weaker analysts would likely produce earnings forecasts with greater error than would stronger analysts. In the longer term, weaker analysts would possibly go out of business. Thus, the degree of divergence would be much less.

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Question 6 a. Source: Topic 7.3 (Level 1) If Lynne works hard (a1), her expected utility is: EU(a1) = = = = = 0.8 (20 + 0.05 240)1/2 + 0.2 (20 + 0.05 60)1/2 2 0.8 321/2 + 0.2 231/2 2 0.8 5.66 + 0.2 4.80 2 4.53 + 0.96 2 3.49

If Lynne shirks (a2), her expected utility is: EU(a2) = 0.1 5.66 + 0.9 4.80 1.5 = 0.57 + 4.32 1.5 = 3.39 Yes, Lynne will likely accept the contract offer since, by working hard, she attains her reservation utility of 3.49. 4 b. Source: Topic 7.3 (Level 1) As manager, Lynne will control the stores accounting system. As a result, she may be tempted to shirk, and falsely report high earnings, so as to receive the high compensation. An audit according to GAAP may protect Kurt against this possibility. 5 c. Source: Topic 7.3 (Level 1) Lynnes expected utilities are now: EU(a1) = = = = = 0.8 (20 + 0.05 180)1/2 + 0.2 (20 + 0.05 50)1/2 2 0.8 291/2 + 0.2 22.501/2 2 0.8 5.39 + 0.2 4.74 2 4.31 + 0.95 2 3.26

EU(a2) = 0.1 5.39 + 0.9 4.74 1.5 = 0.54 + 4.27 1.5 = 3.31 Since Lynne will now receive expected utility less than her reservation utility of 3.49, regardless of which act she takes, she would likely prefer to quit and work somewhere else. However, once signed, contracts are rigid. Hence, Lynne would have to continue as manager but would likely shirk. Note:
If the calculations are correct, full marks may be awarded for a conclusion either that Lynne would quit or would shirk.

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Question 7 Source: Topic 1.2 (Level 1) Capital Asset PV (January 1, 2000) =

= $3,000.00

PV (January 1, 2001) =

= $3,300.00

PV (January 1, 2002) =

$3,993 = $3,630.00 (1.10)

Present value of non-interest bearing note = $1,500/(1.10)3 = $1,126.97 Schedule of Amortization of Discount on Notes Payable Interest Expense and Discount Amortization January 1, 2000 December 31, 2000 December 31, 2001 December 31, 2002 $112.70 123.97 136.36 Present Value/ Carrying Value of Note $1,126.97 1,239.67 1,363.64 1,500.00

a.

XYZ LTD. Income Statement year ended December 31, 2000 Sales revenues Amortization of capital assets Interest expense Net income $ 0 300.00 CR 112.70 DR $ 187.30 CR

b.

XYZ LTD. Balance Sheet December 31, 2000 Capital asset Add amortization $3,000.00 300.00 Notes payable Shareholders equity (SE) Common shares ($3,000.00 $1,126.97) Retained earnings Total liabilities and SE $ 1,239.67

Total assets 3 c. From part (b):

$3,300.00

1,873.03 187.30 $ 3,300.00

Net book value at January 1, 2001 = $3,300.00 $1,239.67 = $2,060.33 Expected net income (10% of $2,060.33) = $206.03

Continued...
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d.

XYZ LTD. Balance Sheet December 31, 2001 Capital assets Accumulated amortization $ 3,000.00 630.00 Notes payable Shareholders equity (SE) Common shares Retained earnings ($187.30 + $206.03) Total liabilities and SE $ 1,363.64 1,873.03 393.33 $ 3,630.00

Total assets Note:

$ 3,630.00

Reasonable rounding differences are acceptable.

END OF SOLUTIONS 100

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CGA-CANADA ACCOUNTING THEORY 1 EXAMINATION June 2002 EXAMINERS COMMENTS

General Comments
Most students did well on this examination. Those who did not do well generally did not provide appropriate explanations when required. Either they did not support their statements with an explanation or the explanation was not relevant.

Specific Comments
Question 1 (Multiple choice; Levels 1 and 2) Most students did well on the multiple-choice items. No particular pattern of errors was noted. Question 2 (Theory of executive compensation; Level 1) Very few students knew that risk in management compensation contracts had no impact on adverse selection. For part (c), the common mistake was discussing minimizing risk compensation from the managers perspective instead of the owners perspective. For all parts, valid alternative answers were accepted. For example, in part (b), focus on short-term perspectives at the expense of long-term perspectives was accepted, and in part (c), a combination of different measures was accepted. Question 3 (Information asymmetry; Level 1; The social significance of properly working securities markets; Level 2) A common error was not differentiating between the required in part (a) and part (b). When answering part (a), students often addressed the question in part (b) instead. In part (c), few students discussed disclosure costs as an impediment to eliminating insider trading. Question 4 (Earnings response coefficients; Level 1) Most students answered this question well. No common errors were noted. Question 5 (Public interest theory of regulation; Information asymmetry; Efficient securities markets; Level 1) Overall, this question was answered well. In part (b), most students said that moral hazard would be reduced by the same forces that reduce adverse selection in the market. However, simply giving all investors the same information does nothing obvious to improve the same investors abilities to observe agent effort. Question 6 (Agency theory; Level 1) This question was generally answered well. The only common error was in part (b), where some students did not discuss Lynnes ability to shirk. Question 7 (Present value model under certainty; Level 1) Performance was weak on this question. Many students did not realize that a single cash flow at the end of a capital assets useful life implies an increasing book value over time. This results in negative amortization expense in 2000. In addition, many students made errors calculating the present value of the non-interest-bearing note. As a result, interest expense was frequently misstated.

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