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Chapter 8: Usefulness of Accounting Information Instructor Manual
Chapter Highlights
Chapter 8 is concerned with the usefulness of external accounting reports for decision making.
The FASB emphasizes decision usefulness in both the conceptual framework project and in
policy deliberations for specific standards. Therefore, it is possible to judge (to some extent) the
benefits of external accounting reports by evaluating their usefulness to investors/creditors, the
FASB’s primary user group.
There are two distinct ways in which the research should be considered. First, it provides a basis
for evaluating the present usefulness of accounting. Second, the research methods themselves
represent techniques and approaches that may be applied in an ongoing way to assess the
usefulness of future or alternative accounting policies. In other words, “economic
consequences” of accounting regulation can be investigated through the research approaches
discussed in the chapter. Clean surplus theory is a new valuation approach which may help
researchers in assessing the relationship between firm valuation and accounting information.
“Benefits” are the focus of the chapter. Questions of costs and the apportionment of costs are
equally important. Some of the recent capital market research has focused on questions of how
accounting policies affect owner wealth. These studies are often cast in terms of agency theory,
and consider the “costs” of accounting policy changes in terms of their wealth impact on owners.
However, the evidence on economic consequences is largely one-sided, focusing on benefits
(e.g., information content) rather than costs. This point should be emphasized and related back
to the question of determining optimal regulation (raised in Chapter 4). All of the research is
empirical except information “economics,” which is included because decision theory illustrates
how information has value in an uncertain decision setting.
Capital market research dominates the empirical literature, which is reviewed. This is
appropriate given its influence over the past 25 years. Other research is important, though it
suffers from some methodological problems such as reliability (surveys) and lack of generality
(experimental research). Another area of research mentioned in the text is the bond rating and
bond risk premium literature (creditors). This research has considered the effects of accounting
numbers and ratios on creditor lending decisions. It too supports the usefulness of accounting
information for decision making. The role of the auditor in terms of providing assurance to users
is also briefly discussed.
One point that is becoming clear is limitations on the efficient markets hypothesis. This point
arises in relation to post-earnings – announcement drift which has been determined from
empirical research and the incomplete revelation hypothesis which is a deductive hypothesis.
Combining these with empirical studies by Ou and Penman also showing that the market is not
as efficient as we might believe and Lev’s study showing low correlation between earnings
numbers and stock returns and the door is certainly open for putting time and effort into
improving accounting standards.
Accounting Theory (8th edition) Page 1 of 17

Questions
Q-1 How is accounting data useful to investors? To creditors?
The financial economics valuation models reviewed in the chapter suggest that accounting
reports are useful in assessing a firm’s future cash flows. This is consistent with SFAC No. 1,
which views the role of accounting reports as aiding in assessing the amounts, timing, and
uncertainty of prospective cash flows. Beaver’s work, while similar in spirit, sees the linkage as
less direct—current earnings predict future earnings, which in turn determine dividend-paying
ability. The difference is that the former view sees a firm’s value as a function of future cash
flows, and the latter sees it as a function of future expected dividends.
Theory is less well developed with respect to the valuation of debt and the role of accounting
information. The work reviewed in the chapter indicates that debt interest rates reflect a risk
premium for the possibility of default. Therefore, the usefulness of accounting lies in aiding
creditors to assess the likelihood of default. In very broad terms, this concern leads to an interest
in future cash flows, viz., debt-servicing ability and the ability to repay or refund the principal
amount of the debt. Hence, information to investors and creditors is complementary. Finally,
both would be interested in accountability aspects of financial statements.
Q-2 In what ways do you think information useful for investors (in assessing future cash
flows) differs from that useful for creditors (in assessing default risk)?
In general, investors and creditors are interested in the amounts, timing, and uncertainties of a
firm's expected future cash flows. Cash payments to equity holders are theoretically unlimited,
and the focus is typically on the upside potential of the expected future cash flows. In contrast,
the cash payment for debt securities is fixed by contract. Hence, the usefulness of accounting
information for creditors lies in its ability to predict the failure of a borrower to make timely
payment of interest and principal. Furthermore, the likelihood of default affects the default risk
premium, which in turn affects the rate the borrower is charged. Finally, we note that interest
bearing debt securities trade infrequently. As a result, theories underlying the usefulness of
accounting information to creditors are not as well developed as they are for equity securities.
Q-3 Besides the primary investor-creditor group, what other user groups could claim to be
stakeholders in the firm? How might their information needs be the same as the the
primary investor-creditor group? How might their information needs differ?
Any individual or entity whose income or payments are affected by a firm's financial wellbeing
has stake in the firm. This would include taxing authorities, utility ratepayers, suppliers of
materials and services, and even current or potential employees. To varying degrees, all of these
stakeholders have an interest in forecasting the expected future cash flows, and in assessing the
firm's financial wellbeing. Their respective information needs depend on the nature of the
explicit or implicit contract. For example, income taxing authorities have a lot in common with

shareholders; their receipts are more directly related to the firm's performance. In contrast,
employees or utility rate payers, at least in the short-term, have contracts that provide for fixed
receipts or rate payments. As such, the needs of these individuals might more closely be related
to creditors.
Q-4 Who are creditors?
Creditors are mainly considered suppliers of materials, services, or capital. They need financial
information about their customers to determine the terms of credit.
Q-5 Why do we sometimes say that the dividend discount model is actually an earnings
model? How does Lintner’s findings relate dividends and earnings?
The dividend discount model is a mathematical model that expresses the value of a stock as the
present value of the expected future dividends. Since dividends are considered to be paid from
earnings, the dividend discount model can be rearranged to express the value of a stock in terms
of the expected future earnings per share and the dividend payout ratio.
Lintner interviewed a number of managers regarding how the managers make a decision
regarding the payment of a cash dividend. Managers indicated that major changes in
"permanent" earnings were the most important determinants of the companies' dividend
decisions. Managers adjusted dividends to reflect expected changes in "permanent" earnings.
Given the seriousness and forward-looking nature of the dividend policy decision, investors
regard cash dividends as credible signals of future performance. A change in the cash dividend
has information content.
Q-6 What is residual income? Abnormal abnormal earnings? Economic profit? EVA?
Residual income is a general term for income in excess of a charge for the capital employed to
generate that income. The concept may be applied to the enterprise as a whole or to the firm’s
common equity. When applied to the enterprise’s operating income and invested capital, residual
income is often called economic profit or Economic Value Added (EVA®). When applied to the
firm’s net income and common equity, residual income is often called residual income or
abnormal earnings.
Q-7 How does EVA differ from economic profit?
Economic Value Added (EVA) is a proprietary form of economic profit developed by Stern
Stewart & Co. EVA begins with residual income [economic profit] and makes a series of
additional adjustments to GAAP accounting that are intended to produce a "better" estimate of
economic profit.

Q-8 What are some advantages and disadvantages of using residual income (including
economic profit and EVA) for performance measurement?
On the positive side, residual income can be used as a company and intra-company performance
measurement tool. It recognizes that capital has a cost. Making capital an explicit part of the
model raises the awareness of using excess capital to generate income; capital has a cost. In
addition, residual income has been shown to have more explanatory power than reported
earnings or cash flow from operations. It can also be used for valuation purposes. On the
negative side, for any given year, the determination of the residual income itself is dependent on
an accurate estimate of the cost of capital. And for valuation purposes, forecasts are crucial.
All forms of residual income are consistent with discounted net cash flows for any book value
and any method of depreciation. Lengthening the depreciable life for fixed assets decreases the
per-period depreciation expense, increases NOPAT, and increases the residual income. In some
cases, it may not be possible to determine whether the residual income calculated is actually due
to management’s efforts or lack thereof.
Residual income is an accounting measure and can be manipulated for any one period.
Furthermore, if improperly applied, residual income could bias management against long-term
investments. Unlike the stock price, which is forward looking, residual income focuses on
historical performance.
Finally, it is not clear that residual income leads to improved stock performance
Q-9 Comment on the following statement. “The residual income model is no different from
the dividend discount model. Therefore, it has no value to investors and analysts.”
The residual income model is consistent with the dividend discount model. However, this does
not mean that it has no value. As indicated above, it can be used as a performance measurement
tool. Unlike net income, residual income recognizes that capital has a cost. Furthermore, residual
income has been shown to have more explanatory power than reported earnings or cash flow
from operations. Finally, Dechow, Hutton and Sloan have shown that the residual income model
allows the user to incorporate non-accounting information into the model to improve its
accuracy.
Q-10 Comment on the following. “Maximizing residual income is the same as maximizing
earnings. Managers should be rewarded for maximizing either one.”
Managers can increase earnings by increasing the amount of capital employed. On average,
investing in more assets translates to increased earnings. The problem is that there is no
guarantee that the additional capital employed is earning its cost of capital. If not, deploying
additional capital is destroying shareholder wealth, similar to investing another $1.00 to gain an
additional $0.80 of intrinsic value.

In contrast, residual income explicitly recognizes that capital has a cost. Managers can only
increase value if they increase income above and beyond that which is required for the amount of
capital employed. Managers should not be rewarded for maximizing earnings if the capital
employed is not earning its cost of capital.
Q-11 Why do managers of Berkshire Hathaway have an incentive to send cash to Omaha?
Managers at Berkshire Hathaway are charged a high rate for the incremental capital that they
employ. If they can generate income in excess of that capital charge, they create value and are
rewarded. If not, they destroy value, and are penalized accordingly. Implicitly, this is an
application of the residual income model.
If managers are not able to use the incremental capital to create value, they have a strong
incentive to lower their invested capital and capital charge by sending the cash to Omaha
(Warren Buffett). This lowers or eliminates any penalty. Cash that cannot be profitably invested
is given to Warren Buffett who distributes it to the individuals who are best able to invest it.
Q-12 Should firm’s capitalize research and development expenditures? Why or why not?
Research and development expenditures are cash outflows. If they are expected to generate
future income, one can make an argument that these expenditures are really investments, which
should be capitalized. This is exactly what is done when firms use EVA. The problem is that
there is less certainty about future income from R&D than there typically is with investments in
other tangible assets. In the worst case, one can easily envision a case in which a firm capitalizes
worthless R&D in order to lower operating expenses and increase reported income.
Q-13 What is clean surplus accounting? What is its role in linking dividends and abnormal
earnings?
Clean surplus accounting is a term indicating that all profit and loss elements go through income.
It relates the current book equity to previous book equity, earnings, and dividends. In the
presence of clean surplus accounting, the residual income model is equivalent to the dividend
discount model.
Q-14 What is the efficient-markets hypothesis?
In its simplest form, the efficient-markets hypothesis states that information is quickly
“impounded” in security prices. Market efficiency refers to informational efficiency, not to social
efficiency (in a Pareto sense).

Q-15 Why does the concept of market efficiency (with respect to information) have no
necessary relation to the quality of accounting information? Why is this distinction
important with respect to accounting policy making?
Market efficiency refers only to the speed with which new information is incorporated into
security prices. It says nothing about the quality of the underlying information. Although, in the
extreme case, if the “information” were purely noise, one would not expect to
Q-16 Why is the efficient-market hypothesis being challenged?
Numerous market anomalies have been reported. The Ou and Penman study, among others,
raises the question of whether all publicly available information is really impounded in security
prices. Also, post-earnings-announcement drift raises the question of why it takes up to 60 days
for earnings announcements to be impounded in security prices. This may be due to transaction
costs being too high for investors to take advantage of new information or possibly to
underreaction to new information by security analysts.
Q-17 What is meant by “information content” and how does capital market research determine
the information content of accounting numbers?
Information content is a term referring to abnormal security returns in response to the release of
new, publicly available information. The research method is described in the chapter. There are
two distinct problems with this research. The first relates to the implicit dual testing for both
market efficiency (the efficient-market hypothesis) and information content (given an
assumption of market efficiency). The second relates to the difficulties in applying asset pricing
models, or even knowing if the asset model used is correct.
Q-18 What is the advantage of being well diversified? Is there a downside? Why or why not?
There are two types of risk. The risk associated with an individual firm or entity is called
unsystematic (diversifiable, unique) risk. This risk can be eliminated with diversification. The
remaining portfolio risk is called systematic (undiversifiable, market) risk. Systematic risk is also
known as the relevant risk as this risk must be borne by the investor.
Diversification does reduce the investor's risk. However the more securities or assets that are
added to an investor's portfolio, the less the investor is able to meaningfully analyze each
security. In the extreme case, a "fully diversified" investor may know or care very little about the
securities he or she holds.

Q-19 If investors are well diversified (e.g., own several hundred stocks), will they have a
greater or lesser need for accounting information? What does this say about
diversification?
As indicated above, an investor who holds many securities does not have the time or resources to
meaningfully analyze them. In this case, the investor is not able to effectively use the accounting
information that is available. Hence, in effect, excessive diversification can lead an investor to be
ignorant of his or her individual investments.
Q-20 What are some limitations of capital market research?
The study of price movements and the pricing mechanism in any market is an imposing task.
Determining cause and effect between information and security prices is especially difficult
because new information is continuously arriving. Since the set of information affecting security
prices is large, it is difficult to isolate the effects of one piece of information. Furthermore, we
are examining only a relatively small group of investors, those at the margin who influence stock
prices. This difficulty means that the tests are going to be somewhat crude rather than precise.
Failure to find evidence of information content should be interpreted cautiously, for the
methodology may is not always capable of detecting information content. For this reason, the
stronger evidence from efficient-markets research exists when there is information content rather
than where there is none.
Another weakness of capital market research is that it is a joint test of both market efficiency and
the model used to estimate the abnormal returns. The absence of price responses is usually
interpreted to mean that the information tested has no information content. This interpretation is
correct only if the market is efficient and if the model used is correct.
Finally market-based research considers only the aggregate effect of individual investor decision
making. That is, the role of accounting information vis-à-vis an individual investor’s decision
making is implicitly modeled as a black box; an “event,” occurs and the effect of this event is
then inferred from whether or not there was an aggregate (market) reaction.
Q-21 What is an event study?
An event study is an empirical research method used in accounting and finance studies to detect
the market’s reaction to some event that should have an impact on the stock price. It considers
stock price changes before and after some event that occurs, attempting to determine information
content.

Q-22 What are abnormal returns (AR) and cumulative abnormal returns (CARs)? What do they
have to do with research in accounting? What do they have to do with accounting
standards?
An event study divides the period related to the event into three “windows:” an estimation
window, the event window, and the post-event window. The “normal” relationship between a
security’s returns and those of the market is estimated during the estimation window. This allows
the researcher to estimate the parameters for the linear regression equation.
After the parameters have been estimated, the regression equation is used to estimate the returns
at the time of and subsequent to the event. The difference between the actual return and the
return expected using the regression equation is called an abnormal return (AR). The sum of the
ARs is known as the cumulative abnormal returns (CAR). In the absence of an event, the ARs
should randomly fluctuate around zero and the CARs should show no upward or downward
trend.
If an unexpected event has occurred, the AR and the CAR should depart significantly from zero
on the date of the event. However, if the market fully and immediately reflects the new
information in the stock price, the subsequent ARs should again randomly fluctuate around zero,
and the CARs should show no trend.
Event studies are a tool to allow researchers to examine the relationship between the security
prices and the information contained in the firm’s financial statements and associated
documentation. This body of research is important to standard setters. The ability of markets to
efficiently allocate resources (allocational efficiency) is crucially dependant on accounting
information for analysis, valuation, and performance measurement. Investors need to know if the
analysis of accounting data is a value-enhancing activity. Furthermore, standard setters need to
know if the existing standards are fulfilling their intended purpose to improve the informational
and allocational efficiency of markets. If not, it might be time for a new standard.
Q-23 Explain Lee’s (2001) view of market efficiency.
The null hypothesis for much of the capital markets research in accounting has been that the
market fully and instantaneously adjusts to new information; the market price is equal to the
security’s intrinsic value. This instantaneous response of the market is an extreme view. Lee
offers an intriguing alternative in which the price convergence toward intrinsic value value is
characterized as a process, which requires time and effort, and is only achieved at substantial
cost to society.
Q-24 Lee (2001) rejects the “naive view” of market efficiency. Explain. If Lee is correct, what
are the implications for capital markets research in accounting?
Lee suggests that we have been asking the wrong questions. Instead of focusing on or assuming
that the market responds instantaneously to new information, he suggests that we consider

fundamental value and market prices as two distinct measures. Furthermore, instead of assuming
or testing market efficiency, researchers should be studying why, when, and how prices converge
to intrinsic value, and how current market prices might be improved.
Q-25 For event studies, the post event window is typically short (days or months). What are
some issues associated with examining longer event windows (e.g., years)?
For all practical purposes, event tests assume that aside from the event tested, all other things
remain the same (ceteris paribus). However, the longer the post-event window, the lower the
likelihood that ceteris paribus does not hold. If it does not, it becomes more difficult to draw
meaningful conclusions from the data.
Q-26 What do we mean when we say that capital market research involves a joint test of both
market efficiency and the model used to estimate abnormal returns?
In order to test the markets response to new information, the researcher must have a model of
expected security returns. If the market does not appear to be efficient with respect to a piece of
information, several possibilities may exist. The market might not be efficient with respect to the
information analyzed. However, it is also possible that the model used to generate the expected
returns might be flawed, providing for a flawed test. Unfortunately, it is impossible to separate
the two.
Q-27 Describe the general findings from capital market research concerning the information
content of accounting numbers and the effects of alternative accounting policies.
Accounting income numbers have evidenced information content in a wide variety of tests. It
must be emphasized, though, that stock prices are probably affected as much or more by
nonaccounting data. The research on alternative policies is ambiguous. Recent studies have used
agency theory arguments to evaluate differences that, on the surface, appear to have noncash
implications. However, indirect consequences on owner wealth are offered to explain the stock
price responses.
Q-28 Why is the choice between the FIFO-LIFO inventory methods an interesting issue in
capital market research?
The early capital market studies were motivated by tests of whether or not investors were
“fooled” by bookkeeping differences that had no direct cash flow effects on firms. This is an
important issue with respect to how sophisticated we assume users are—it will also affect the
style and substance of accounting reports. For example, the FASB presumes that users are
sophisticated. For the most part, the research rejects the naive investor hypothesis, though there
are troubling anomalies such as the FIFO-LIFO research, which tends to support the notion that
investors react naively to reported earnings without considering how those numbers have been
constructed in terms of alternative (arbitrary) accounting policies.

Q-29 As an investor, how would you react to a company changing is inventory accounting
from FIFO to LIFO? Why?
It would depend on the level of analysis. Change inventory accounting from FIFO to LIFO
would ordinarily result in higher cost of goods sold and lower accounting income. However,
because the same inventory accounting method must be used for both financial reporting and
income tax purposes, taxable income will be lower as well. If the firm pays income taxes, the
firm's income tax bill should decline, and after-tax cash flow should rise. This would be good for
shareholders.
Q-30 Over the years, the research findings regarding changing from FIFO to LIFO have
varied? Why do you suppose this is the case?
This issue, along with oil and gas accounting continues to produce some of the most anomalous
results in capital market research. As with the oil and gas issue, the technical aspects of the
research designs have varied across studies, as have the results. The research in this area
highlights the problem of using capital market studies to study subtle issues of accounting policy
choice (as opposed to more general questions such as the information content of reported
earnings).
Q-31 Why may accounting policies with no direct cash flow consequences indirectly affect
investors or creditors?
The argument derives from the agency or contracting theory. Existing contracts can be affected
by changes in accounting methods that affect accounting numbers used in the contracts. Typical
uses of accounting numbers for contracting are in the areas dealing with restricting dividends,
restricting new debt issues, and providing incentive compensation contracts with managers.
Q-32 Why is it argued that capital market research cannot determine the optimality of
accounting policies even for the limited investor-creditor group?
Because of externalities associated with financial reporting (free-riders), a market mechanism

does not operate to determine the optimal production of information.
Q-33 How do market-level and individual decision-maker analyses complement one another in
studying the usefulness of accounting information to investors and creditors?
Market-level studies (i.e., capital market research) treat the individual decision maker as a “black
box,” whereas the decision-maker studies focus explicitly on how decision makers respond to
specific information cues in simulated laboratory decision making.

Q-34 Lev talks about the low correlation between earnings and stock returns. Ou and Penman
paper discuss the possibility of making abnormal returns based upon published financial
data. Are these papers in conflict with each other or complementary to each other?
The papers complement each other. Since Ou and Penman see a predictive role for accounting in
a market that may not be efficient, then Lev’s call for improved accounting measures certainly
makes sense. Furthermore, even if the market were highly efficient, Lev’s call for improved
accounting standards can be interpreted as being concerned with the quality of the signal picked
up by the market, which should result in the market providing a more meaningful equating of
risk and return for individual securities. Wyatt (1983) essentially makes this point.
Q-35 What is post-earnings announcement drift (PEAD)?
If markets are efficient, security prices respond instantly and fully to new, relevant information.
Post-earnings-announcement drift refers to situations in which it takes a much longer period of
time for the market to adjust to unexpected earnings announcements. In some cases, it takes up to
60 days for the full effect of unexpected earnings announcements to be impounded in security
prices.
Q-36 Why does post-earnings-announcement drift challenge the efficient-markets hypothesis?
Post-earnings-announcement drift is a contradiction of the efficient-markets hypothesis. The

problem lies with the slow length of time it takes for new information to be impounded in
security prices.
Q-37 Why does post-earnings announcement drift appear to be more pronounced with smaller
firms? What could be done from a company perspective to rectify this situation? What
could be done from a standard setting perspective to mitigate the effects of PEAD?
Post-earnings-announcement drift appears to be more pronounced for smaller firms. There is

evidence that financial analysts underreact to very fundamental signals stemming from securities,
which in turn, lead to forecast errors and incomplete security price adjustments. There is also
evidence that shareholders do not distinguish well between cash flow portions of earnings and
the accrual segment thereof. Another possibility is that in some cases, transaction costs are too
high relative to the potential gain that can be earned from the mispricing of the securities.
Finally, post-earnings-announcement drift appears to be inversely related to the number of
experience analysts following the stock. With smaller firms, there are fewer analysts following
the stock. Indeed, some small firms have no analysts following them.
Smaller firms might be able to mitigate the problem by providing more disclosure and discussion
of cash flows and other analyses normally provided by analysts.

Accounting standards that improve the quality of financial reporting might eliminate some or all
of the post-earnings-announcement drift, providing for better valuation of securities and
ultimately, better allocation of resources in the economy.
Q-38 What is the incomplete revelation hypothesis?
The incomplete revelation hypothesis is a hypothesis that may help to show why markets are less
efficient than we have previously believed. One reason is that it may be more difficult to
determine the effect of some numbers, particularly if they are buried in footnotes. Hence, stock
option disclosures in the footnotes (SFAS No. 123) may be more difficult to assess than if they
were in the body of the income statement. Also, the presence of noise traders may impact upon
market efficiency. These individuals have their own purposes which may not bear directly upon
assessing risk and return. For example they may simply be rebalancing their portfolios,
attempting to attain more liquidity or simply be acting upon whims or irrational tips.
Q-39 Suppose an accounting event occurs and there is no market reaction. What should we
conclude?
It is sometimes hard to say. It could be that information was made available earlier via non-
accounting means. An example might be industry information revealed by a competitor. It is also
possible that another piece of news has the exact opposite effect as the accounting event. For
example, a firm may have a very positive earnings announcement on the same day that the
Federal Reserve announces that it will increase interest rates.
Q-40 Give some examples in which accounting information is not the most timely source of
information affecting security prices.
There are many examples. In this space we offer only a few. A competitor might announce that
the industry is in a slump. This is apt to affect all firms in the industry. A supplier might
announce that its employees are on strike. This could jeopardize future inputs to a firm.
Commodity prices might increase or decrease for a variety of reasons, and have an immediate
affect on transportation companies.
Q-41 Instead of employing capital markets research techniques (e.g., event studies) why don’t
we just ask investors how they would react to a hypothetical event? Why don’t we ask
managers why they make specific accounting changes?
This is an age-old question. Will the investors and managers provide a truthful answer? If they
provide a truthful answer, will they provide an objective answer? Will their hypothetical answer
be the same as their actual reaction? Finally, it is difficult to survey enough investors and
managers in a timely fashion. In financial markets, we see the effects of decisions in real time.

Q-42 Why is it important to improve the quality of accounting standards?
Accounting information is useful in making valuation and compensation decisions. These

decisions affect securities pricing and ultimately, the efficient allocation of capital in the
economy (allocational efficiency). Directly or indirectly, everyone has a vested interest in the
correct understanding of the financial wellbeing of firms. Since accounting standards have a
substantial affect on the type and quality of accounting information provided, we would argue
that accounting standards have an affect on the efficient allocation of capital in the economy.
With better standards, we would expect improved allocational efficiency.
Q-43 What do pensions have to do with a company’s operating performance? What do

pensions have to do with the firm’s financing and investment decisions?
Operating performance and the ability to generate cash eventually affects the firm's financing
and investment decisions. Poor operating performance might lead to increased financing needs or
to a reduction in investment expenditures. The converse is true for good operating performance.
It is possible that poor operating performance and sub-optimal investment decisions leads to
pension underfunding. On the other hand, it is also possible that poor management of the pension
fund in the form of severe underfunding or poor investment decisions, eventually lead to poor
operating performance and sub-optimal investment decisions.
It appears that investors frequently do not fully recognize that the severe underfunding has
negative valuation effects. Why this happens is yet to be resolved. Even when investors
recognize the severe underfunding, it is possible that they may not adequately factor in the
implications of that underfunding, such as difficulty in refinancing at favorable terms or or the
inability to refinance at all.
Q-44 There is evidence that investors do not fully recognize the valuation effects of severe
pension underfunding. (See for example Franzoni, Francesco and José M. Marín (2006).
Why do you suppose this is the case? What changes could be made to mitigate this
problem?
Franzoni and Marín present evidence that the market significantly overvalues firms with severely
underfunded defined benefit pension plans. Furthermore, the effects of the overvaluation persists
for a long time. Perhaps investors do not analyze the information contained in the footnotes as it
relates to pension funding. It is also possible that even when they examine the footnotes, some
investors might not understand the information provided. Finally, it is necessary for investors to
recognize the implications from the information provided.
For example, a pension liability is a debt—a promise to pay—similar to a bond. Firms that have
severe underfunding might find it difficult to refinance existing debt at favorable terms. Worse
yet, it is possible that such firms may not be able to refinance existing debt at all. These kinds of

constraints may affect a firm's ability to undertake future investments and eventually have a
negative affect on future operating performance.
It is possible that improved disclosure or better accounting standards might help investors to
understand the significance a firm's underfunded pension. Including both pension assets and
pension liabilities on the balance sheet might also be useful.
Q-45 Why are accounting ratios valuable for predicting bankruptcy? What cautions do we need
in evaluating accounting ratios?
Accounting-based ratios have been very useful in discriminating between firms that subsequently
went bankrupt and those that did not. Prior to bankruptcy, companies that eventually go bankrupt
tend to have financial ratios that differ from companies that do not go bankrupt. Predictability up
to five years prior to bankruptcy has been demonstrated. Firms are complex enterprises, and it is
not easy to reverse a positive or negative trend.
Note, however, that we must be very careful in drawing conclusions. Companies with “poor”
ratios will not necessarily go bankrupt in the future. However, unless a company's operating or
financial performance changes, bankruptcy is more probable for companies with poor financial
ratios.
Q-46 Accounting earnings are useful in predicting one-year ahead cash flows. Is this
sufficient? Why or why not?
From a financial economic perspective, the value of a firm is equal to the present value all
expected future cash flows. Clearly, the value of the firm depends on much more than the
oneyear-ahead cash flow. Nevertheless, the one-year-ahead cash flow might be indicative of
subsequent cash flows.
Q-47 Why do high levels of accruals appear to be mispriced?
Richardson, Sloan, Soliman, and Tuna find empirical evidence that suggests that accruals are
related to earnings persistence. In addition, the less reliable the accruals, the lower the earnings
persistence. Furthermore, they find that the market does not fully price the less reliable accruals.
Future stock returns appear to be negatively related to accruals, and the negative relation is
stronger for less reliable accruals. Liu and Qi provide evidence that the potential mispricing of
accruals is substantial.
Q-48 Evaluate Stewart’s (2009) discovery of a single overarching ratio, EVA Momentum,
which is “superior to all other ratios.”
Stewart III, G. Bennett (Spring 2009). “EVA Momentum: The One Ratio That Tells the Whole
Story,” Journal of Applied Corporate Finance, 74–84.

Stewart has done another outstanding job of marketing the next financial discovery; however, as
was the case with EVA, we doubt the statement will weather academic empirical research
studies. There is no panacea, no single metric to tell the whole story. However, the idea will
likely enhance consulting revenues.
Cases, Problems, and Writing Assignments

1. The usefulness of accounting data to investors and creditors for predictive purposes is
necessarily forward looking. However, under generally accepted accounting principles,
financial statements are constructed primarily as an historical record.
Required:
(a) What limitation does this impose on the usefulness of financial statements for
predictive purposes, and how is this limitation evident from the research reviewed in the
chapter?
(b) Provide examples of important forward-looking events that either are not reported in
financial statements or are not reported in a timely manner.
(c) Why may the feedback value of audited financial statements make them very
important to investors and creditors even though predictive value is not necessarily high?
(a)
The FASB conceives of accounting as an information system with the emphasis mainly on
prospective cash flows. Since accounting systems are, by construction, historical records, they
are necessarily backward looking. Therefore, feedback value is going to be better achieved than
predictive value. Consistent with this is the low explanatory power of some capital market
research. Unexpected earnings “explain” only about 5 percent or less of a firm’s abnormal stock
return around the time of earning’s announcements. The capital market literature presumes that
accounting functions as an information system, but it is more likely that its main role is for
contracting and hence feedback purposes.
(b)
A good example is the mutually unperformed (executory) contract in which the firm and an
outside party have an unperformed contract. By convention, such contracts do not meet the
criteria for recognition.
(c)
If accounting is primarily a feedback system, it is nevertheless useful precisely for this reason.
From a contracting perspective, accounting is important in bringing about control and
accountability to investors and creditors, and it is for this reason that accounting numbers are
used in writing contracts. For example, debt contracts with restrictive covenants, and
employment contracts with managers, especially incentive compensation agreements, also
feedback and accountability. They are also helpful to users in predicting cash flows.

A retail company begins operations late in 2000 by purchasing $600,000 of merchandise.

2.
There are no sales in 2000. During 2001 additional merchandise of $3,000,000 is
purchased. Operating expenses (excluding management bonuses) are $400,000, and sales
are $6,000,000. The management compensation agreement provides for incentive
bonuses totaling 1 percent of after-tax income (before the bonuses). Taxes are 25 percent,
and accounting and taxable income will be the same. The company is undecided about
the selection of the LIFO or FIFO inventory methods. For the year ended 2001, ending
inventory would be $700,000 and $1,000,000, respectively, under LIFO and FIFO.
(a)How are accounting numbers used to monitor this agency contract between owner and
managers?
(b)Evaluate management incentives to choose FIFO versus FIFO?
(c)Assuming an efficient capital market, what effect should the alternative policies have
on security prices and shareholder wealth?
(d)Why is the management compensation agreement potentially counterproductive as an
agency-monitoring mechanism?
(e)Devise an alternative bonus system to avoid the problem in the existing plan.
(a)The bonus is part of the compensation agreement and is limited to financial performance.
(b) See computations that follow.

FIFO LIFO
Sales $6,000,000 $6,000,000
Cost of Sales 2,600,000 2,900,000
Gross Margin 3,400,000 3,100,000
Operating Expenses 400,000 400,000
Operating income 3,000,000 2,700,000
Taxes on operating income (25%) 750,000 675,000
Basis for Bonus 2,250,000 2,025,000
Bonus (1%) $ 22,500 $ 20,250
In terms of the bonus alone, management would choose FIFO over LIFO. However,
after-tax cash flows will be higher under LIFO.
FIFO LIFO
Gross Margin $3,400,000.00 $3,100,000.00
Operating Expenses 400,000.00 400,000.00
Bonus (1%) 22,500.00 20,250.00
Pre-tax Income 2,977,500.00 2,679,750.00
Taxes (25%) 744,375.00 669,937.50
Difference in taxes paid is $74,437.50 in favor of LIFO ($744,375 minus $669,937.50).
(c) LIFO should increase firm value due to higher positive cash flows arising from lower taxes,
compared with FIFO.

(d) The agreement is a poor one because the bonus encourages a personal gain of $2,250 to the
managers for choosing FIFO at a cost of $74,437.50 in higher taxes to the firm. This choice
reduces shareholder wealth.
(e) Some alternative arrangement might include non-allocation bases such as sales or cash flow
operations, or net cash flows (see chapter 13), or nonaccounting-based incentives such as stock
option plans. Another alternative might be a bonus plan based on LIFO, with management’s
bonus percentage being slightly higher than it presently is to allow for the lower income under
LIFO.
Critical Thinking and Analysis

1. How do you think the efficient-markets hypothesis impacts the drafting of accounting
standards? Bear in mind that many questions have been raised about the efficient-markets
hypothesis itself.
It’s nice that accounting information is presumably rapidly impounded into security prices but
the FASB shouldn’t—and hasn’t—been seduced by the EMH. First of all, the quality of
accounting information can be improved (see Lev, 1989 and Wyatt, 1983). Second, the FASB
should not be indifferent between providing information within the body of the financial
statements themselves and disclosure in footnotes and supplementary information. Third, the
FASB should try and increase publicly available information and reduce inside information. In
short, the EMH should not allow the FASB to slough anything off but should be a spur to
improving financial information.
2. To what extent should the liquidity measures revisions be considered if LIFO were to be
eliminated from U.S. GAAP? Provide examples of those likely measures that would be
affected.
This is a problem somewhat like the one faced when FASB proposed making all leases be placed
on the balance sheet. In the case of leases, ratios were affected, severely in some cases, and
companies voiced very strong opposition. The opposition was strong enough that FASB
reversed its position.
Inventory days supply on hand, current ratio, debt to asset ratios: they are all affected if a
company values its inventory using LIFO, but then replaces the method with FIFO or weighted
average valuation methods. Gross margins would likely increase on the income statement.
Implementation costs to revise any agreements based on ratios might be costly to specific firms.
The question relates to short-term implementation issues, a cost-benefit issue.

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The basic Bessemer process is of great value to England and to
the continent of Europe by enabling manufacturers to use their
native ores, which are usually too high in phosphorus for the acid
process, so that before this invention nearly all of the ores for making
Bessemer steel were imported from Sweden, Spain, and Africa.
The basic process has found little development in the United
States, because the great abundance of pure ore keeps the acid
process the cheaper, except in one or two special localities. Where
the basic process is profitable in the United States, it is worked
successfully.
At about the time that Bessemer made his invention William
Siemens, afterward Sir William, invented the well-known
regenerative gas-furnace. A Frenchman named Martin utilized this
furnace to melt steel in bulk in the hearth of the furnace, developing
what was known for some years as Siemens-Martin steel, or open-
hearth steel; the latter name has prevailed, and open-hearth steel is
the fourth of the general kinds of steel mentioned in the beginning of
this chapter.
At first open-hearth steel was made upon a specially prepared
sand bottom, by first melting a bath of cast iron and then adding
wrought iron to the bath until by the additions of wrought iron and the
action of the flame the carbon and silicon of the cast iron were
reduced until the whole became a mass of molten steel. Sometimes
iron ore is used instead of wrought iron as the reducing agent; this is
called the pig and ore process. Now in general practice wrought iron,
steel scrap, and iron ore are used, sometimes alone and sometimes
together, as economy or special requirements make it convenient.
It was found as in the Bessemer, so in the open-hearth, the
sulphur and the phosphorus of the charge remained in the steel,
making it necessary to see that in the charge there was no more of
these elements than the steel would bear.
This is known now as the acid open-hearth process.
After the success of the basic Bessemer process was assured
the same principle was tried in the open-hearth; a basic bottom of
dolomite or of magnesite was substituted for the acid sand bottom,
and care was taken to secure a basic slag in the bath.
Success was greater than in the Bessemer; phosphorus was
eliminated and a better article in every way was made by this
process, now used extensively over the whole civilized world.
This is the basic open-hearth process.
Neither the basic Bessemer process nor the basic open-hearth
removed sulphur, so that this element must still be kept low in the
original charge, until some way shall be found for its sure and
economical elimination.
The four general divisions, then, are:
Converted or Cemented Steel.
Crucible-cast Steel.
Acid
Bessemer Cast Steel.
Basic
Acid
Open-hearth Cast Steel.
Basic
Little or nothing more will be said of the first kind, as it has been
so thoroughly superseded by the cast steels. After a statement of the
most patent applications and uses of the different cast steels the
discussions which follow will apply to all, because practically they are
all governed by the same general laws.
II.
APPLICATIONS AND USES OF THE
DIFFERENT KINDS OF STEEL.
Where exact uniformity of composition is not a necessity, and

where welding is required, cemented or converted steel may be
preferred to cast steel, because the converted bar retains the
occluded layers of slag which give to wrought iron its peculiar
welding properties, and for this reason blister- or shear-steel may be
welded more easily and surely than cast steel. For tires, composite
dies, and many compound articles this steel will do very well, and it
may be worked with good results by almost any smith of ordinary
skill; however, owing to the more uniform structure and the greater
durability of the cast steels, they have, even for these purposes,
almost entirely displaced the more easily worked, but less durable,
cemented steels.
CRUCIBLE-CAST STEEL.
For all purposes crucible-steel has proved to be superior to all
others; it is well known to all experienced and observing workers in
steel that, given an equal composition, crucible is stronger and more
reliable in every way than any of the other kinds of steel.
This may read like a mere dictum, and it might be asked properly,
What are the proofs?
The proofs are wanting for two reasons: first, because crucible-
steel is so expensive that except for gun parts, armor, and such uses
where expense could be ignored, crucible-steel never came into
extensive use for structural purposes; second, that while thousands
upon thousands of tests of the cheaper steels are recorded and
available to engineers very few of such tests have been made on
crucible-steel, simply because it has not been used for structural
purposes.
On the other hand, intelligent makers of crucible-steel have for
self-preservation made careful study of the relative properties of the
different steels in order that they might know what to expect from the
cheaper processes. In this way they have surrendered boiler-steel,
spring-steel, machinery-steel, battering-tool steel, cheap die-steel,
and many smaller applications; not because they could not produce
a better article, but because the cheaper steels met the requirements
of consumers satisfactorily, and therefore they could not be expected
to pay a higher price for an article whose superiority was not a
necessity in their requirements.
Still this stated superiority is proven best by the fact that many
careful consumers who have special reasons for studying durability
as against first cost adhere to the higher priced crucible-steel for
such uses as, for instance, parts of mining- and quarrying-drills,
high-speed spindles, in cotton-mills, and in expensive lathes and
machines of that kind.
This sort of testimony should be more conclusive than that of
interested steel-makers, because these men pay their own money
for the higher priced material, and because men who are most
careful of the quality of their produce and of their reputation are the
most clear-headed and most sensible men of their class; they have
the best business and the greatest success. Such men are not fools;
they may be depended upon to try everything of promise with the
greatest care, and to use only that thing which pays them best. In
fact such men do use the cheaper steels freely wherever they can do
so safely.
A good car-spring, carriage-spring, or wagon-spring is made from
Bessemer or open-hearth steel, a spring that will wear out the car or
carriage; it would be stupid then to buy more expensive steel for
such purposes, for even if crucible-steel would wear out two cars or
two wagons the owner never expects to take the springs out of an
old wagon to put them under a new one.
On the other hand, the watch-spring maker or the clock-spring
maker will find a great advantage in using the very best crucible-
steel that can be made.
A sledge, a maul, or a hammer can be made of such excellent
quality from properly selected Bessemer or open-hearth steel that it
would be foolish for makers of such tools to continue to buy crucible-
steel, even though they knew it to be superior, for lower first cost in
such cases outweighs superiority that cannot be shown for a number
of years.
Locomotive-boilers, crank-pins, slide-rods, connecting-rods, and
springs can be made of such good quality of Bessemer or open-
hearth steel that, like the “one-horse shay,” the whole machine will
wear out at the same time practically, and that a good long time;
there would be no reason in this case for using crucible-steel for one
or more of these parts, although twenty-five years ago it was by
means of crucible-steel that engineers learned to use steel for these
purposes.
A good cam for an ordinary machine, such as a shear or punch,
may be made of Bessemer or open-hearth steel where greater
strength and endurance are required than can be had in cast iron; on
the other hand, makers of cams for delicately adjusted high-speed
machines where intricacy and accuracy are necessary will touch
nothing but the very best crucible-steel of fine-tool quality for their
work. It is of no use to suggest the greater cheapness of the other
steels; they have tried them thoroughly, and they know that in their
case the highest priced is the cheapest.
This superiority of crucible-steel has been doubted, because the
claim appeared to rest solely upon the statements of steel-makers,
and not to have any scientific basis; there is, however, a scientific
basis for the fact. Given three samples of steel of say the following
composition:
Open-
Crucible.
hearth. Bessemer.
Carbon 1.00 1.00 1.00
Open-
Crucible.
hearth. Bessemer.
Silicon .10 .10 .10
Phosphorus .05 .05 .05
Sulphur .02 .02 .02
Copper, arsenic,
traces
etc.
Why should there be any difference in the strength of the three?
In mere tensile strength in an untempered bar the difference might
not be very great, although all experienced persons would expect the
crucible to show the highest; but it is not necessary to make the
claim, because we have not enough tests of crucible-steel to enable
us to establish a mean, and one or two tests are insufficient to
establish a rule in any case.
There have been made, however, hundreds of tests of hardened
and tempered samples by the most expert persons, with one
invariable result: the crucible-steel is incomparably finer and stronger
than the others, and the open-hearth is almost invariably stronger
and finer than the Bessemer.
Unfortunately for the argument these tests cannot be recorded so
as to be intelligible to the non-expert, because we cannot tabulate
the result of the touch of the expert hand or the observation of the
experienced eye.
For a time it was popular to call these differences mysteries, and
so let them pass; this, however, was not satisfactory, and the
question was studied carefully for the physical reasons which must
exist.
Much thought led to the conclusion that the reason lay with the
three elements oxygen, nitrogen, and hydrogen; they are known to
exist in greater or less quantity in all iron and steel.
It is known that the presence of oxygen beyond certain small
limits produces red-shortness and general weakness; it is probably a
much more hurtful element than phosphorus or sulphur, but no
quantitative method for its determination has been worked out; there
is an effort now being made to develop a simple and expeditious
oxygen determination, and it is to be hoped that it will be successful.
In the crucible no more oxygen, hydrogen, or nitrogen can get
into the steel than is contained in the material charged and in the
atmosphere of the crucible, or than may penetrate the walls of the
crucible during melting. In the open hearth the process is an
oxidizing one, and besides the charge is swept continuously by hot
flames containing all of these elements.
In the Bessemer process the conditions are worse still, as these
elements are all blown through the whole mass of the steel.
We know the effect of oxygen and how to eliminate it practically.
Percy gives the effects of nitrogen as causing hardness and
extreme brittleness, and giving to iron or steel a brassy lustre. Such
a brassy lustre may be seen frequently in open-hearth or Bessemer
steel, and occasionally in crucible-steel. When seen in crucible-steel
it is known to be due to the fact that the cap of the crucible became
displaced, exposing the contents to the direct action of the flame. Of
the effect of hydrogen we know less; there is no reason apparent
why it may not be as potent as the others.
Ammonia in sufficient quantity to be detected by the nose has
often been observed in open-hearth and Bessemer steel.
To settle the nitrogen question Prof. John W. Langley developed
some years ago a very delicate and accurate process for the
determination of nitrogen even in minute quantities; the process was
tedious and expensive, so that it was not adapted for daily use; it
involved the careful elimination of nitrogen from all of the reagents to
be used, requiring several days’ work, in each case to prepare for
only a few nitrogen determinations.
By this process it was found, in every one of many trials, that
crucible-steel contained the least amount of nitrogen, open-hearth
steel the next greater quantity, and Bessemer steel the greatest
amount. He found no exceptions to this. For many years great efforts
had been made both in Europe and in the United States to make by
the Bessemer or the open-hearth process a cheap melting-product
to be used in the crucible instead of the expensive irons which so far
have proved to be necessary to give the best results.
There appeared to be no difficulty in making a material as pure
chemically, or purer, than the most famous irons in the world, and
this material was urged upon the crucible-steel makers. Careful tests
of such material failed to produce the required article; in fact it was
demonstrated over and over again that an inferior wrought iron
would produce a stronger steel than this very pure steel melting-
material, and crucible-steel makers were compelled to adhere to the
more costly irons to produce their finer grades.
Prof. Langley determined the nitrogen in a given quantity of open-
hearth and Bessemer steel; this same material was then melted in a
crucible, and it was found that the resulting ingots contained nearly
as much nitrogen as the original charge. The quantity was reduced
slightly; still this steel contained more nitrogen than any other sample
of crucible-steel that he had tested. The physical test of this trial
steel showed the usual weakness of the Bessemer or open-hearth
steel, as compared to crucible-steel.
The next step was to try to get rid of nitrogen by the use of some
affinity, as oxygen is removed by manganese. Boron and titanium
seemed to be the most feasible elements; boron appeared to offer
less chance of success, and titanium was selected. A ferro-titanium
containing six per cent of titanium was imported from Europe at
some expense. As the most careful and exacting analyses of this
material failed to reveal a trace of titanium, it was not used.
After many futile efforts Langley succeeded, by means of electric
heat, in reducing rutile and producing a small quantity of an alloy of
iron and titanium. A trial of this alloy, although not conclusive, led to
the belief that such an alloy could be used successfully to eliminate
nitrogen; but as its cost, about two dollars a pound, was prohibitory
of any commercial use, the subject was not pursued farther.
Although we know these elements only as gases, there is no
reason to suppose that their atoms may not be as potent, when
added to steel, as atoms of carbon, silicon, phosphorus, or any other
substance.
Such are the facts for crucible-steel as far as they are known; it is
vastly more expensive than any other kind of steel, yet for the
present it holds its own unique and valuable place in the arts.
For all tools requiring a fine edge for cutting purposes, such as
lathe-tools, drills, taps, reamers, milling-cutters, axes, razors, pocket-
knives, needles, graving-tools, etc.; for fine dies where sharp outline
and great endurance are required; for fine springs and fine
machinery parts and fine files and saws, and for a hundred similar
uses, crucible-cast steel still stands pre-eminent, and must remain
so until some genius shall remove from the cheaper steels the
elements that unfit them for these purposes.
As stated before, crucible-steel is divided into fifteen or more
different tempers, ranging in carbon from .50 to 1.50. Each of these
tempers has its specific uses, and a few will be pointed out in a
general way.
.50 to .60 carbon is best adapted for hot work and
for battering-tools.
.60 to .70 carbon for hot work, battering-tools, and
tools of dull edge.
.70 to .80 carbon for battering-tools, cold-sets, and
some forms of reamers and taps.
.80 to .90 carbon for cold-sets, hand-chisels, drills,
taps, reamers, and dies.
.90 to 1.00 carbon for chisels, drills, dies, axes,
knives, and many similar purposes.
1.00 to 1.10 carbon for axes, hatchets, knives,
large lathe-tools, and many kinds of dies and drills if
care be used in tempering them.
1.10 to 1.50 carbon for lathe-tools, graving-tools,
scribers, scrapers, little drills, and many similar
purposes.
The best all-around tool-steel is found between .90 and 1.10
carbon; steel that can be adapted safely and successfully to more
uses than any other temper.
At somewhere from .90 to 1.00 carbon, iron appears to be
saturated with carbon, giving the highest efficiency in tools and the
highest results in the testing-machine except for compressive
strains. More will be said upon this point in treating of the carbon-
line.
Much more could be said about the uses for the different tempers
of steel; it would be easy to write out in great detail the exact carbon
which experience has shown to be best adapted to any one of
hundreds of different uses, but it would only be confusing and
misleading to a great many people.
It is within the experience of every steel-maker that men are just
as variable as steel, and the successful steel-maker must familiarize
himself with the personal equations of his patrons. One man on the
sunny side of a street may be making an excellent kind of tool from a
certain grade and temper of steel, and be perfectly happy and
prosperous in its use. His competitor on the shady side of the street
may fail in trying to use the same steel for the same purpose and
condemn it utterly.
The know it all agent will condemn the latter man with an
intimation that his ears are too long, and so lose his trade. The
tactful agent will supply him with steel a temper higher or a temper
lower, until he hits upon the right one, and so will retain both men on
his list; and both men will turn out equally good products.
Few men know their own personal equations, and the best way
for a steel-user to do is to tell the steel-maker what he wants to
accomplish, and put upon him the responsibility of selecting the best
temper.
It costs no more to make and to provide one temper than
another; therefore the one inducement of the steel-maker is to give
his patron that which is best adapted to his use. This plan puts all of
the responsibility upon the steel-maker, just where it ought to be,
because he should know more about the adaptability of his steel
than any other person.
BESSEMER STEEL.
Bessemer steel is probably the cheapest of all grades of steel;
that is to say, it can be made so rapidly, so continuously, and in such
enormous quantities that a greater output per dollar invested can be
made than by either of the other processes. Again, the work is
controlled and operated by machinery to a much greater extent than
in the other processes; therefore the cost of labor per ton of product
both for skilled and unskilled labor is less than in the crucible or the
open-hearth method.
This being the case, it might be inferred that the result would be
the eventual driving out of all other steels by this, the cheapest. This
would be the inevitable result if Bessemer steel were as well adapted
to all purposes as either of the other kinds of steel; there are
limitations which prevent this.
The source of heat in the Bessemer process is in the combustion
of the elements of the charge, there is no extraneous source of heat;
therefore, if the heat be too cold, there is no way to remedy it unless
it be by the addition of ferro-silicon and more blowing; if it be too hot,
it may be allowed to stand a few minutes to cool. Still in either case
the remedy is somewhat doubtful. This limitation must not be taken
as being fatal to good work, for in skilful hands such cases are rare,
and the product is generally fully up to the standard of good work.
As there is no known sure way of stopping the blow at a given
point in the operation to produce a steel of required carbon, it is
usual to blow clear down, that is, to burn out all of the carbon
practically and then to re-carbonize by the addition of spiegel-eisen
or ferro-manganese. It is necessary, also, to add the manganese in
one of these forms to remove the oxygen introduced during the blow;
this must be done quickly, and all accomplished before the metal
becomes too cold for pouring into ingots.
So little time for reactions is available that it is doubtful if the
material is ever quite as homogeneous as it can be made by either
of the other processes.
Notwithstanding these limitations, which are not mentioned to
throw doubt upon the process, but merely to inform readers fully so
as to enable them to judge rightly as to what may be expected,
enormous quantities of good, reliable Bessemer steel are made to
meet many requirements.
For good, serviceable, cheap rails Bessemer steel stands pre-
eminent, and if it found no other use it would be difficult to
overestimate the benefit to the world of this one great success.
Bessemer steel is used largely for a great number of purposes,
Bessemer billets being now as regular an article of commerce as pig
iron.
For wire for all ordinary purposes; for skelp to be worked into
butt-welded and lap-welded tubing; for wire nails, shafting,
machinery-steel, tank-plates, and for many other uses, Bessemer
steel has absorbed the markets almost entirely.
For common cutlery, files, shovels, picks, battering-tools, and
many such uses it contests the market with open-hearth steel; and
while many engineers now specify that their structural shapes,
plates, beams, angles, etc., must be of open-hearth steel, there are
many eminent engineers who see no need for this discrimination,
they being satisfied that if their requirements are met the process by
which they are met is a matter of indifference.
OPEN-HEARTH STEEL.
As in the Bessemer process, so in the open-hearth, carbon and
silicon are burned out, phosphorus is removed on the basic hearth,
and the sulphur of the charge remains in the steel. During the
operation oxygen and nitrogen are absorbed by the steel, although
not quite so largely as in the Bessemer process, so that practically
the chemical limitations are the same in each.
The open-hearth reductions are much slower than in the
Bessemer, each heat requiring from five to eight hours for its
completion; the furnace must be operated by a skilled man of good
judgment, so that more time and more skilled labor per ton of
product are required than in the Bessemer, and the making of an
equal quality as cheaply in the open hearth is problematical. The
open hearth has extraneous sources of heat at the command and
under the control of the operator, and there need be no cold heats,
and no too hot heats.
The time for reactions is much longer, and for this reason they
ought to be more complete, and they are so in good hands; yet it is a
fact that, as the operation is a quiet one compared to the Bessemer,
and not nearly so powerful and energetic, a careless or unskilful
operator may produce in the open hearth an uneven result that is
quite as bad as anything that can be brought out of a Bessemer
converter. The process that eliminates the human factor has not yet
been invented.
For fine boiler-plates, armor-plates, and gun parts open-hearth
steel has won its place as completely as has the crucible for fine-tool
steel or the Bessemer for rails.
For all intermediate products there is a continued race and keen
competition, so that it is impossible to draw any hard and fast line
between the products of the three processes where they approach
each other; the only clear distinctions are at the other extremes.
Owing to the power to hold and manipulate a heat in the open-
hearth it is safe to say that it is superior to the Bessemer in the
manufacture of steel castings; and owing to its much greater
cheapness it is difficult for the crucible to compete with it at all in this
branch of manufacture.
In conclusion of this chapter it is safe to say that in good hands
these processes are all good, and each has its own special function
to perform.
III.
ALLOY STEELS AND THEIR USES.
In addition to the four general kinds of steel treated of in the last

chapter there are a number of steels in the market which contain
other metals, and which may be termed properly alloy steels, to
distinguish them from carbon steel, or the regular steels of world-
wide use which depend upon the quantity of carbon present for their
properties. The most generally known of the alloy steels is the so-
called Self-hardening steel.
Self-hardening steel is so called because when it is heated to the
right temperature,—about a medium orange color,—and is then
allowed to cool in the air, it becomes very hard. This steel is so easily
strained that it is impossible, as a rule, to quench it in water without
cracking it. It may be quenched in a blast of air without cracking, and
so be made much harder than if it be allowed to cool more slowly in
a quiet atmosphere. If it be quenched in oil or water, it will become
excessively hard, much harder than when quenched in air, and it will
almost invariably be cracked, or if it be not cracked it will be so
excessively brittle as to be of little use.
Self-hardened steel is so hard in what may be called its natural
condition, that is, in ordinary bars, that it cannot be machined, drilled,
planed, or turned in a lathe.
By keeping it in an annealing-furnace at about bright orange heat
for about twenty-four to thirty-six hours, and then covering it with hot
sand or ashes in the furnace, and allowing about the same time for it
to cool, it may be annealed pretty thoroughly so that it may be
machined readily.
When annealed in this way and formed into cutters of irregular
shape, or dies, it has been found so far not to be economical or well
adapted to such work, so that up to the present time annealing is
more of a scientific than a useful fact.
Self-hardened steel has the useful property of retaining its
hardness when heated almost to redness; therefore it may be used
as a lathe or similar cutter upon hard work, such as cutting cast iron
and other metals, at a much higher speed than is possible with
ordinary steel, which would be softened by the heat generated by the
high speed. This property makes self-hardened steel very useful and
economical for many purposes.
Self-hardened steel is an alloy of iron, carbon, tungsten, and
manganese, and some brands contain chromium in addition to
these, and it is claimed, and probably truly, that the chromium
improves the quality of the steel.
It was supposed for a long time that tungsten was the hardener
that gave to self-hardened steel its peculiar properties. By means of
an open hearth, steel was produced containing about 3% tungsten
and little carbon and manganese. This steel worked like any mild
steel, except that it was hot-short and difficult to forge. It was not
hard and had no hardening properties; that is, it did not harden in the
ordinary sense when quenched in water. The addition of carbon to
this steel, keeping the manganese low, produced a steel very difficult
to work, which would harden like ordinary steel when quenched, and
which had no self-hardening properties whatever. The addition of
2½% to 3% of manganese to this steel produced self-hardening steel
having the usual properties.
Manganese, then, is the metal that gives the self-hardening
property, and this might have been anticipated by considering the
properties of Hadfield’s manganese steel, which, when it contains
above 7% manganese, cannot be annealed so that it can be
machined or drawn into wire. From this it might be inferred that
tungsten is not a necessary constituent of self-hardened steel; that it
performs an important function will be shown presently. Tests of the
iron-tungsten alloy low in carbon gave only a small increase in
strength above ordinary low cast steel containing little carbon; it was
difficult and troublesome to work, and more expensive than the
common steels, so that its production presented no advantages.
When carbonized, it was fine-grained and could be made
exceedingly hard; it was brittle, and compared to very ordinary cast
steel comparatively worthless.
In self-hardened steel tungsten is the mordant that holds the
carbon in solution and enables the steel to retain its hardness at
comparatively high temperatures. That it does hold the carbon in
solution may be proved in a moment by a beautiful test, first
observed by Prof. John W. Langley.
When a piece of carbon steel is pressed against a rapidly running
emery wheel, there is given off a shower of brilliant sparks which
flash out in innumerable white, tiny stars of great beauty; it is
accepted that this brilliancy is due to the explosive combustion of
particles of carbon.
When a steel containing as much as three per cent of tungsten is
pressed against the wheel, the entire absence of these brilliant
flashes is at once noticeable, and if there be an occasional little flash
it only serves to emphasize the absence of the myriads.
Instead there is an emission of a comparatively small number of
dull particles, and there is clinging to the wheel closely a heavy band
of a deep, rich red color. This red streak is distinctive of the presence
of tungsten.
By testing various pieces it was soon observed that different
quantities of tungsten gave different sizes of red streaks; as tungsten
decreased the width of the band diminished and the number and
brilliancy of carbon sparks increased. As little as .10 tungsten will
show a fine red line amidst a brilliant display of sparks, and it soon
became possible to determine so closely by the streak the quantity
of tungsten present that the ordinary analyses for tungsten became
unnecessary, except in occasional important cases where analysis
was used merely to confirm the testimony of the wheel.
Self-hardening steel, then, is a steel which, owing to the
presence of manganese and tungsten, hardens when quenched in
quiet air, and which retains its hardness almost up to a red heat.
It may be forged between the temperatures from orange to bright
orange; it cannot be worked safely outside of this range. The more
quickly it is quenched the harder it will be; and it may be annealed so
that it can be machined readily. Therefore it is not self-hardening; it
simply has all of the properties of carbon steel modified profoundly
by tungsten and manganese. If a piece of this steel will not harden
sufficiently by cooling in the air quietly, that difficulty may be
remedied by cooling it in an air-blast; if quenching in an air-blast will
not give sufficient hardness, the steel had better be rejected, for
quenching in oil or water means almost certain destruction.
As stated before, the range of temperature in which self-
hardened steel can be forged safely is much smaller than for a high-
carbon steel; it is harder at this heat than carbon steel and not so
plastic, so that it requires more care and more heats in working it to
tool-shapes.
This steel is so sensitive that it often occurs in redressing it that it
will crumble at a heat that was all right in the first working. This
difficulty may be remedied by first cutting off the shattered part with a
sharp tool,—it must be cut hot,—then heating the piece up to nearly
a lemon color, heating it through without soaking it in the fire, and
then allowing it to cool slowly in a warm, dry place. After this
treatment the steel may be heated and worked as at first. This
treatment does not anneal the steel soft, because the heat is not
continued long enough, and the cooling is not sufficiently slow; it
does relieve the strains in the steel, so that it is plastic and
malleable.
This treatment is good in any high steel which has become
refractory from previous working.
Self-hardened steel is not as strong in the hardened condition as
good high-carbon steel; it has not been used successfully for cutting
chilled cast iron, for instance. If made hard enough to cut a chill, it is
so brittle that the cutting-edge will crumble instead of cutting; if the
temper be let down enough to stop the crumbling, the steel will be
softer than the chill, and the edge will curl up instead of cutting.
Owing to the retention of hardness at a higher temperature than
carbon steel will bear this steel is capable of doing a great amount of
work at high speed, so that for much lathe-work it is cheap at almost
any price.
Owing to its brittle, friable nature its use is limited to the simpler
forms of tools, and to a narrower range of work than is possible with
carbon steel.
CHROME STEEL.
An alloy of chromium with carbon steel has been before the
public for many years, and greater claims have been made for it than
experience seems to justify. Chrome steel is fine-grained and very
hard in the hardened state, and it will do a large amount of work at
the first dressing; upon redressing it deteriorates much more rapidly
than carbon steel and becomes inferior; it is believed that this is due
to a rapid oxidation of the chromium.
It is claimed for it that it will endure much higher heats without
injury than carbon steels of the same temper. Intending purchasers
will do well to satisfy themselves upon these points before investing
too heavily.
SILICON STEEL.
Steel containing two to three per cent of silicon was put upon the
markets, and great claims were made for it.
It is exceedingly fine-grained and hardens very hard; it is brittle,
much more liable to crack in hardening than ordinary steel, and it is
not nearly so strong as carbon steel.
It is made cheaply enough as far as melting goes, but it may not
be melted dead, and therefore sound, because long-continued high
heat will destroy it; therefore the ingots are more honeycombed than
well-melted carbon steel ingots. The steel will not bear what is
known as a welding-heat in steel-working; it is hot-short; for this
reason the bars are more seamy than is usual in carbon steel.
Added to this the hot-shortness makes it so difficult to work that the
labor cost is high. Altogether, then, silicon steel is expensive, and it
presents no extra good qualities in compensation.
MANGANESE STEEL.
The glassy hardness, brittleness, and friability of ferro-
manganese and of spiegel-eisen are well known; these are products
of the blast-furnace, and the manganese ranges all the way from say
10% up to 80%.
Steel containing from 1% to 3% of manganese is about as brittle
and almost as unworkable as spiegel-eisen, and a fair deduction
would be that manganese above very small limits will not form any
useful alloy with iron. Many a general law of nature has been based
upon much more meagre data and has been announced with a great
flourish of trumpets; such discoveries are usually heard of no more
after the first blare has died away.
R. A. Hadfield, of Sheffield, England, is an inquirer who wants to
know, and who is willing to travel the whole road in order to find out.
Hadfield discovered that an alloy of iron and manganese containing
from 7% to 20% of manganese was a compound possessing many
remarkable properties. This alloy is now known as manganese steel.
Manganese steel is both hard and tough to a degree not found in
any other metal or alloy.
It is so hard and strong that it cannot be machined with the best
of tools made of the finest steel. Castings made of it may be battered
into all sorts of shapes as completely as if they were made of the
mildest dead-soft steel; still they are too hard to be machined.
The ordinary hardening process toughens this steel instead of
hardening it to brittleness.
This steel is non-magnetic, and this property alone would give it
exceedingly great value if the steel could only be worked into the
required shapes.
Up to this time all attempts to anneal this steel have failed, and
this persistent hardness is the best proof that manganese is the real
hardener in self-hardened steel. So far carbon and manganese have
not been separated in this steel or in any other. Persistent attempts
have been made to produce manganese steel low in carbon, but all
have been failures, because any operation that burned out the
carbon took the manganese with it. The hope was that a non-
magnetic alloy might be produced that would be soft enough to work.
This may yet be accomplished, and if it should be another great step
in the arts will have been taken.
Hard, tough, strong, non-magnetic—what great things may not
come out of this when it has been worked out finally?
Since this was written carbonless manganese has been
produced which is claimed to contain 98% + of manganese and no
carbon, but at present it is sold at $1 per pound. If it can be produced
more cheaply, it may lead to a workable non-magnetic alloy of iron
and manganese which may prove to be of great value to electricians
and to watchmakers.
The uses of manganese steel are large and growing, and it must
be regarded as having an established and a prominent place.
It has been stated that in self-hardened steel and in manganese
steel manganese is the hardener; it should be borne in mind that
carbon is always present, that it is the one great hardener, but its
hardening property in the absence of manganese depends directly
upon rapidity of cooling. By rapid cooling steel containing carbon is
made harder than glass, and by slow cooling it may be made softer
and more ductile than ordinary wrought iron.
Self-hardened steel may be annealed so that it can be machined,
but it is by no means as soft and ductile as well-annealed carbon
steel. Manganese steel has not been annealed at all; it cannot be
annealed by any of the well-known annealing processes; some new
way of doing it must be discovered. Therefore it is proper to say that
the peculiar hardening properties of these two steels are due to
manganese.

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Accounting Theory Conceptual Issues

in a Political and Economic

Accounting Theory Conceptual Issues in a Political and

Accounting Theory Conceptual Issues in a Political and

Accounting Theory Conceptual Issues in a Political and

Financial Accounting in an Economic Context 8th Edition

Conceptual and Historical Issues in Psychology 1st

Financial Accounting in an Economic Context 8th Edition

Financial Accounting in an Economic Context 9th Edition

Issues in Economics Today 8th Edition Guell Solutions

Accounting Theory (8th edition) Page 1 of 17

Accounting Theory (8th edition) Page 2 of 17

Q-4 Who are creditors?

Q-7 How does EVA differ from economic profit?

Accounting Theory (8th edition) Page 3 of 17

Accounting Theory (8th edition) Page 4 of 17

Q-14 What is the efficient-markets hypothesis?

Accounting Theory (8th edition) Page 5 of 17

Q-16 Why is the efficient-market hypothesis being challenged?

Accounting Theory (8th edition) Page 6 of 17

Q-20 What are some limitations of capital market research?

Q-21 What is an event study?

Accounting Theory (8th edition) Page 7 of 17

Q-23 Explain Lee’s (2001) view of market efficiency.

Accounting Theory (8th edition) Page 8 of 17

Accounting Theory (8th edition) Page 9 of 17

Because of externalities associated with financial reporting (free-riders), a market mechanism

Accounting Theory (8th edition) Page 10 of 17

Q-35 What is post-earnings announcement drift (PEAD)?

Q-36 Why does post-earnings-announcement drift challenge the efficient-markets hypothesis?

Post-earnings-announcement drift is a contradiction of the efficient-markets hypothesis. The

Post-earnings-announcement drift appears to be more pronounced for smaller firms. There is

Accounting Theory (8th edition) Page 11 of 17

Q-38 What is the incomplete revelation hypothesis?

Accounting Theory (8th edition) Page 12 of 17

Q-42 Why is it important to improve the quality of accounting standards?

Accounting information is useful in making valuation and compensation decisions. These

Q-43 What do pensions have to do with a company’s operating performance? What do

Accounting Theory (8th edition) Page 13 of 17

Q-47 Why do high levels of accruals appear to be mispriced?

Accounting Theory (8th edition) Page 14 of 17

Cases, Problems, and Writing Assignments

Accounting Theory (8th edition) Page 15 of 17

A retail company begins operations late in 2000 by purchasing $600,000 of merchandise.

(b) See computations that follow.

Difference in taxes paid is $74,437.50 in favor of LIFO ($744,375 minus $669,937.50).

Accounting Theory (8th edition) Page 16 of 17

Critical Thinking and Analysis

The question relates to short-term implementation issues, a cost-benefit issue.

Accounting Theory (8th edition) Page 17 of 17

Where exact uniformity of composition is not a necessity, and

In addition to the four general kinds of steel treated of in the last

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