AC3103: SEMINAR 2

2-10. Explain why, under non-ideal conditions, it is necessary to trade

off relevance and reliability when estimating future cash flows. Define
relevance and reliability as part of your answer.
Relevant information is defined as information that enables investors to predict
the firms future cash flow. Reliable information is information that faithfully
represents without bias what it is intended to represent and is precise.
Where conditions are not ideal, the estimation of the PV of the future firms cash
flow (i.e. relevant information) require specification of a set of possible future
cash flow amounts (i.e. state of nature). The probabilities of the state of nature
are subjective and based on estimation. Such estimation are subject to errors
and possible bias, reducing reliability.
Conversely, reliable information such as the historical cost of a capital asset or
face value of debt, tends to be low in relevance because this basis of valuation
involves no direct estimates of future receipts or payments. Historical
information quickly lose relevance since market value, expected future receipts
and interest rates change over time. Therefore, relevance and reliability
characteristics of accounting information must be traded off, since an increase in
one leads to a decrease in the other.
2-29. A theoretically correct measure of income does not exist in the
real world in which accountants must operate.
Required:
a. What is meant by the phrase a theoretically correct measure of
income?
A theoretically correct measure of income is the net income of a firm for a
period calculated on a present value basis; that is, accretion of discount on
opening firm present value, plus or minus any differences between
expected and actual cash flows for the period. Alternatively, net income is
theoretically correct if it is calculated so as to include the changes during
the period in the market values of all assets and liabilities, adjusted for
capital transactions (providing that the markets for all assets and liabilities
exist and work reasonably well).
b. Why does a theoretically correct measure of income not exist in
the real world?
A theoretically correct measure of income does not exist because ideal
conditions do not exist. As a result, future cash inflows and outflows from
assets and liabilities cannot be reliably estimated. This means that present
value-based net income is not theoretically correct since theoretical
correctness
requires
complete
reliability.
Furthermore,
market
incompleteness can exist in the absence of ideal conditions. Then,
properly working market values for all assets and liabilities of a firm need
not exist. As a result, net income based on net changes in market values is
not theoretically correct either.

c. Outline the tradeoffs between relevance and reliability under

historical cost accounting and current value accounting. Consider
both situations where reasonably well-working market values
exist.
Historical cost accounting is reasonably reliable because the cost of an
asset is usually an objective and verifiable number. However, while cost is
also relevant at time of acquisition, it may lose relevance over time due to
changes in market prices, interest rates and economic conditions, which
will change the assets current value. To the extent reasonably-working
market prices exist, current value accounting is more relevant than
historical cost while retaining reliability. However, if such market values do
not exist, current valuation requires estimates of fair value, cash flow
estimates, or the use of models. Estimates of cash flows face serious
problems of reliability, as do the inputs into valuation models.
3-5. In Section 3.7.1, the text refers to the study of Kim and Cross, who
reported that the ability of current earnings to predict next periods
operating cash flows exceeds the ability of current operating cash flows
to predict next periods operating cash flows. Give an explanation for
this result.
The argument is probably made because of the lumpiness of certain cash
receipts and disbursements. Cash payments for major purchases such as capital
assets, and for borrowings such as loan proceeds, tend to occur at discrete
intervals in large amounts. As a result, a firm could have what appears as a
favourable cash flow, but one which results, for example, from the proceeds of a
large borrowing rather than from recurring operating transactions. Since financial
statement users are primarily interested in the firms ability to generate cash
from operations, it would be necessary to separate out the effects on cash flows
of major transactions such as these.
Even within the category of operating cash flows, there can be lumpiness of
receipts and payments -- for example, a large collection on account may come in
shortly after year end. Under a strict cash basis, this would not appear as a cash
flow in the year. Under accrual accounting, of course, the account receivable (an
accrual) and revenue from such a transaction would be included in the financial
statements regardless of whether the cash was collected yet or not.
In effect, the FASB seems to be arguing that accrual accounting enables a better
prediction of average or longer-run future operating cash flows or, more
generally, of future firm performance, by recording the inflows (revenues) and
outflows (expenses) in the period in which the major economic activity relating to
those flows takes place. This seems reasonable since accruals anticipate
operating cash inflows or outflows. The recording of accruals results in a more
timely recognition of these cash flows.
4-1. Two firms, of the same size and risk, release their annual reports
on the same day. It turns out that they each report the same amount of
net income. Following the release, the share price of one firm rose
strongly while the other rose hardly at all. Explain how it is possible for
the market to react positively to one firms annual report and hardly at

all to the other when the firms are similar in size, risk and reported
profitability.
The differing market response could be explained by a difference in the markets
expectations of earnings. The net income of the firm that had the strong reaction
may have been higher than expectations, whereas the net income of the other
firm may have been equal to or less than expectations. Another reason could be
a difference in the quality of earnings. The firms may have used different
accounting policies. For example, one firm may have used declining-balance
amortization and successful-efforts accounting, whereas the other may have
used straight-line and full-cost methods. If the accounting policies of one firm are
more relevant and/or reliable than those of the other, the main diagonal
probabilities of its information system would be higher, inducing a stronger
market response. Finally, the informativeness of price could have differed
between the two firms, although this is less likely when the firms are the same
size. However, the firm whose share price changed only slightly may have
released more information during the year, say by quarterly reports, forecasts, or
manager speeches, and the efficient market would build this information into the
share price prior to the earnings announcement.
4-5. On January 21, 1993, The Wall Street Journal reported that General
Electric Cos fourth quarter 1992 earnings rose 6.2% to $1.34 billion or
$1.57 a share, setting a new record and bringing the earnings for 1992
to $4.73billion or $5.51 a share. After adjusting for low persistence
items, 1992 earnings from continuing operations were up about 10%
from the previous year.
The Journal also reported that forecast made by analysts averaged
$1.61 per share for the 4th quarter of 1992 and from $5.50 to $5.60 per
share for the whole year. One analyst was quoted as saying that 1992
wasnt a bad year for GE despite the downturn in the stock market on
the day of the earnings management.
Yet, on the same day the fourth-quarter earnings were announced,
General Electric Cos share price fell on the NYSE.
Required:
a. Give 3 reasons to explain why this could happen
One reason is that 1992 fourth quarter earnings came in lower than
expected by analysts and the market, and, for the whole year, earnings
were near the lower end of analysts forecasts. Since expected 1992
earnings would already be built into the firms share price by the efficient
market, actual earnings lower than expectations would cause the share
price to fall, as investors revised downwards their beliefs about future firm
performance.
A second reason is that GEs earnings quality may have changed. Perhaps
GE switched to less relevant and/or reliable accounting policies during
1992. If the efficient market did not know this until the 1992 earnings were
released, it would then ask why the change in accounting policies to
lower earnings quality? This could trigger a decline in share price at that
time.

A third reason is the possibility of noise traders. There may have been a
large increase in the supply of GE shares coming to the market due to
random factors.
b. Use the Sharpe-Lintner CAPM to explain how the new information
caused the current price to all. Calculations are not required.
The new earnings information apparently lowered investors prior
expectations of GEs future profitability and dividends. In terms of
equation (4.2), the markets expectation of Pjt + Djt fell. Since, from
equation (4.3), E(Rjt) is determined by Rf, j and E(RMt), none of which is
directly affected by the new earnings information, the current price Pj,t-1
in the denominator of equation (4.2) (here, t-1 is January 21, 1993) must
fall to restore the equality of this equation.
4-11. A major reason for the rarity of formal financial forecasts in
annual reports is the possibility of lawsuits if the forecast is not met,
particularly in the US. On Nov 17 1995, The WSJ reported that the SEC
was supporting a bill before the U.S Senate to provide protection from
legal liability resulting from forecasts, providing that meaningful
cautionary statements accomplished from forecast.
Required:
a. If firms are discouraged from providing financial forecasts by the
prospects of litigation, how could this lead to a negative impact
on the working of securities markets? Can you give an argument
that a litigious environment might actually improve the working
of securities markets?
Failure to forecast can have a negative impact on the working of securities
markets because share prices are then less able to incorporate
managements plans and expectations about future firm performance. As
a result, firms with excellent future prospects may be undervalued and
firms with poor prospects overvalued, relative to fundamental value.
Consequently, the capital market is less able to direct scarce investment
capital to its most productive uses. If managers face a lower prospect of
legal liability for poor forecast accuracy, the number of firms issuing
forecasts would increase, other things equal. However, these forecasts
may be biased, less accurate and less credible to investors, since
managers face fewer penalties for poor forecasting. The net impact on
the working of capital markets would depend on the net effect of these
two opposing factors. If the second effect dominated, for example, so that
poorer quality forecasting overcomes their increased availability, a
litigious environment would reduce this effect, thereby helping capital
markets to work better.
b. Explain how the passage of a bill such as that mentioned above
might benefit investors.
Passage of the bill would benefit investors if the first effect above
dominates the second. This would be more likely if cautionary
statements were made, as recommended, since investors would then be

alerted to the possibility of forecast inaccuracy. This would benefit

investors if it alerts them to accept the forecasts with a grain of salt,
that is, to make their own evaluation of the plausibility and credibility of
the forecasted information.
c. Explain how passage might benefit firms.
Passage would benefit firms if greater investor confidence in the market as
a level playing field resulted from increased incidence of forecasting.
This would reduce the markets concern about lemons and estimation risk,
thereby increasing demand for shares and lowering firms costs of capital.