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57 Cards in this Set
- Front
- Back
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The Measurement Approach to DecisionUsefulness |
- Measurement approach to decision usefulnessimplies greater usage of current values in the financial statements proper. - Providing this can be done with reasonablereliability this provides investors with better information to make decisions-Investors still make predictions but this methodenables better predictions |
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Market ineffciency: Limited attention |
investors do not have time to process allavailable information |
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Market inefficiency: Conservative |
investors are conservative and thus do notchange as much as bayes thermo would predict |
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Market inefficiency: Overconfidence |
investors put too much weight oninformation they have collected |
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Market inefficiency: Representativeness |
investors assign too much weight to info thatconfirms their beliefs |
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Market inefficiency: Self-attribution bias |
individuals attribute good results to theirabilities (if price falls the belief in ability does not fall) |
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Market inefficiency: Momentum |
individuals accept good news but questionbad news |
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Market inefficiency: Motivated Reasoning |
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Prospect Theory |
investors separately evaluate pros and consof a risky stockTheory is based on the physiologicalconcept of narrow framing where individuals look at problems in too narrow of aframework to economize mental effort Theory includes loss aversion where investorssell winners and hold losers which leads is called the disposition effect |
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Post Announcement Drift |
once a firms earnings are known the infoshould be quickly digested by investors and incorporated into the price |
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Value in Use |
-measured by discounted present value ofcash to be received or paid with respect to the use of an asset of liability -since this provides the most informationon future economic aspects of a corporation -but since the asset might be changed in howit may not be that reliable |
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Fair Value |
- IFRS 13: FV is the price that would bereceived to sell an asset or paid to transfer a liability in an orderlytransaction between market participants at the measured date- the basis of evaluation is also termed anexit price this measures the valueby calculating the opportunity cost of not using the item |
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Levels of Fair Value Accounting |
Level 1: assets and liabilities for which areasonably well-working market price existsLevel 2: assets and liabilities for which amarket price can be inferred from similar items Level 3: assets and liabilities for which amarket value cannot be observed or inferred. Then, the firm shall use the bestavailable information about how a market participant holding the item wouldvalue the asset i.e. how much they could sell the asset for |
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Current Value Accounting and the incomestatement |
-gains and losses on fair value would berecorded on the i/s too-some argue matching revenue to expenses isthe best i.e. historical cost method-though some argue this increasesmanagements stewardship cause they control the opportunity cost of the assets |
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Current Value Accounting and the A/R and A/P |
-since cash is expected soon discountingvalues is negligible |
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Current Value Accounting and Cash Flows Fixed by Contract |
some instances cash is fixed-new financial vs operating lease fv rulesmake financials calculated as asset by lessee |
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CVA: Lower-cost-of-market rule |
-generally used for inventories -IAS 2 requires values to be written downif cost falls below market price i.e. written down |
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CVA: PPE |
-IAS 16 allows revaluation instead ofhistorical -if it meets impairment then it should beincluded in income statement |
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CVA: Financial Instruments |
-is a contract that creates a financialasset of one firm and a liability or equity instrument for another firm -i.e. cash, equity, financial contract ect. |
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CVA: Primary Financial Instruments |
standard setters back down on fv accounting -since the 07-08 financial instrumentswrite downs were large IFRS added ability to use an adjustment based oninterest rate and risk, future value of the asset |
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CVA: Long Run changes to FV |
-with IAS 9 coming in 2015 all financialassets any changes will go down as amortization |
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CVA: The fair value option |
-IAS 9 allows companies to value assets as fairvalue if it reduces amortization mismatch |
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CVA: Loan Loss Provision |
When loans are calculated corporations musthave a provision for loan lost-some issues b/c like other estimationsmanagers have control on outcome |
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CVA: Derivatives |
-contracts with underlying price, interestrate, fx or other -generally require or permit settlement ofcash on delivery of the asset -if traded on market the fv calculated |
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CVA: Hedge Accounting |
-hedging uses derivatives to remove risk -risk from non perfect hedge is called abasis risk |
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CVA: Accounting for purchased good will |
-good will is difference of fv of assetsand liabilities and the purchase price -often amortized but management did notagree -managers would do a “pooling of interest”treating an acquisition as a merger to not get any good will -would also use pro-forma income on incomestatement to remove amortization from goodwill |
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PAYOFFASSYMETRY |
WANTTHE FIRM TO PERFORM WELL BUT ALSO WANNA PROTECT THEIR OWN INTERESTS |
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Efficient Contracting Theory |
-studies the role of financial accountinginformation in moderating infro asymmetry between contracting parties to haveefficient contracts -efficient means optimal trade off of costsand benefits -theory includes implicit contracts whichis continuing business interactions |
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Sources of Efficient Contracting Demand: LENDERS |
-concerned about info assym because lendeescould hide info useful for the lenders |
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Sources of Efficient Contracting Demand: SHAREHOLDERS |
- shareholders want good accounting becausemanagement derive their compensation from it -also does not create stock overvaluationby management |
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Policies for efficient contracting: Reliability |
-lenders with payoff asymmetry preferreliable information over relevant info -thisis because they do not gain from firm growth -shareholders prefer relevant (inferred) |
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Policies for efficient contracting: Conservatism |
-lenders prefer unrealized losses overunrealized gains - top demanders because loss indicatecompanies in financial distress |
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Policies for efficient contracting: Contract Rigidity |
-since contracts are ridged any accountingin the contracts might be affected by changes in accounting standards -this increase the likely hood of aviolation thus sometimes stipulations are entered into the contracts to preventthis -they could freeze the accounting policiesbut costs much more -better way is to give managers options inGAAP -opensup possibility for opportunistic behavior -when managers change policies oroperations due to standard changes the system changes |
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Employee Stock Options |
-firms would understate compensation costby not recording options -black scholes helps in pricing -cost can be thought as opportunity costsas only receiving option price for stock-pump and dump -managersraising stock price and dumping their options-managers opposed adding eso because itwould increase capital cost and decrease stock price but likely did not likethe results of lower earnings |
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Agency theory |
o Branch ofgame theory that studies the design of contracts to motivate a rational agentto act on behalf of a principal when the agent’s interests would otherwiseconflict with those of the principal o Actionsare non-cooperative and are motivated by the contract o First-best: a contract where direct monitoring ispossible § Shares risk between the two § Frequently unattainable, leading to infoasymmetry (moral hazard) as owners do not know what “hard work” constitutes forthe manager o Mostefficient alternative is to give the manager a share of profits, by tyingcompensation to a performance measure that is jointly observable § Net income is an example of a variable that is informative about manager effort (notfully informative though) |
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- Net incomegives the manager an information advantage, in that the owner cannot observeunmanaged net income, allowing the manager to manage earnigns to maximizecompensation |
Like IDK |
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Revelationprinciple |
o Equatescompensation amount regardless of income reported; encourages truthfulreporting of income o Fails asmanager may still not report truthfully, as low earnings may lead totermination; alternatively, high income may not be reported if compensation iscapped o Essentially,for this work, manager must know that owner will not use the truth againstthem, which cannot be guaranteed; it is therefore unlikely that this willeliminate EM o Solutionis to restrict EM through GAAP (strong corporate governance) |
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Problemarises with net income as performance measure because the characteristicsneeded for it to be a strong performance measure do not necessarily make it aneffective input for investment decisions |
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Informationasymmetry in agency relationship |
o Ownercannot monitor manager beahviour; tying compensation to net income iseffective, but gives manager a vested interest in how net income is measuredand leads to selection of accounting policies which may not align with theinterests of ownership o Similarscenario under debt covenant arrangements; manager will want to avoid costlyviolations and will therefore manipulate income through accounting policies toavoid these violations |
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- Net incomecan be useful if accountants increase the sensitivity and precision of thismeasure, through corporate governance - Completelyeliminating EM is not cost effective; controlling it through GAAP can restoreincentive for manager not to shirk |
Net income can be useful if accountants increase the sensitivity and precision of this measure, through corporate governance - Completely eliminating EM is not cost effective; controlling it through GAAP can restore incentive for manager not to shirk |
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Executive Comp. |
- Internaland market forces may help control managers’ tendencies to shirk, but do noteliminate them |
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Executive Comp. |
- Incentivesystems that tie compensation to firm performance are necessary for efficientcontracting o Must haveincentives not only for short-term performance, but for long-term as well;these two factors balance each other out and prevent bad EM |
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Executive Comp. |
- Shareprice is not a good short-run indicator due to number of external factors; netincome better reflects short-run performance due to immediate effects o Greaterefficiency balanced against benefits of controlling manager’s decision horizon o DysfunctionalSR effort discouraged due to long run decrease in earnings |
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Executive Comp. |
- Risk mustbe placed on manager in order to encourage effort; too much risk, however, willlead to underinvestment that will not benefit shareholders |
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Executive Comp. |
- The above points underline the idea that a mix of performance measures is most desirable in order to balance the objectives and actions of managers |
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Powertheory |
- suggeststhat executive compensation is driven by managerial opportunism, not efficientcontracting o CEO’sexercise control over the board, which increases as corporate governanceweakens o Accountantscan counter this by improving disclosure; regulators can help by limiting theamount of compensation by reducing how much can be deducted for tax purposesand expanding the amount of info available to stakeholders, who will takeaction to eliminate inefficient plans |
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Conclusions: Executive Compensation |
- Manageriallabour markets reduce severity of moral hazard through the proper evaluation ofmanager reputation - Exec compcontracts balance risk, incentives, and decision horizono Accomplishedthrough a combination of salary, bonus, equity-based compensation, and goldenparachutes - CEO’sexploit power to increase comp; regulators and accountants can counter thisthrough improved disclosure |
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Earnings management |
choice by manager ofaccounting policies, or real actions, affecting earnings so as to achieve somespecific reported earnings objective - Can beused to protect firms from unforeseen events when contracts are rigid andincomplete - Too muchmay reduce the usefulness of financial reports for investors, especially if notproperly disclosed - Reducesmanager’s motivation to exert effort due to ability to use earnings managementto smooth managerial compensation over time - Accruals-basedearnings management will lead to greater peaks and valleys in earnings becauseaccruals reverse o That is,earnings management cannot indefinitely postpone bad results from apoorly-performing firm |
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Typesof earnings management: Taking a bath |
(reporting large loss one year to boost futureearnings) |
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Types of earnings management: Income minimization |
(similar toabove, but less than extreme; typically used during periods of highprofitability) |
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Types of earnings management: Income smoothing |
(to allow for consistent compensation, to reduceprobability of covenant violations, and to signal to the markets the persistentearning power of the firm) |
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Types of earnings management: Income maximization |
(for bonus purposes, or to ensure compliance withdebt covenants) |
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Othermotivations for earnings management: |
o Reduce thelikelihood of covenant violations; will avoid coming close in order to avoidconstraints on their management of the firm o To meetinvestor expectations § Market penalizes companies who fall short farmore than companies that exceed targets o StockofferingsMaximizeIPO return by maximizing income in the lead up; rational investors take thisinto account in their valuations |
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Positiveeffects of earnings management |
o Blockedcommunication (credibly communicating insider info to investors that cannot bedirectly disclosed – done through discretionary accrual management that thenreveals insider info about future profitability) o Overall,EM can inform investors, reduce estimation risk, and favourably affect shareprices |
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Bad sideof EM (supplement with slides – betterthan textbook) |
o OpportunisticEM, especially in the lead up to share issuance o Excessivewritedowns, which reduce future amortization costs and absorb other costs thatwould be included in operating expense |
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Conclusions:EM Pt 1 |
- Madepossible by the fact that true net income doesn’t exist - Accountingpolicy flexibility enables managers to opportunistically manage earnings - Reducesreliability and sensitivity - Positivein that it provides management with the ability to react to unanticipatedshocks to earnings when contracts are rigid and incomplete o Can alsohelp managers to credibly communicate inside info to investors |
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Conclusions:EM Pt 2 |
- Managersabuse because: o They failto accept securities market efficiency (as fully efficient markets would snuffout opportunity for EM) o Able tohide bad EM behind poor disclosure - Accountantscan reduce bad EM by: o Disclosinglow-persistence items o Reportingeffects of previous writeoffs on current earnings |
