Advanced Test 1 Update Exam Questions|
Already answered| GRADED A+
WorldCom - ANSWER-Overstated earnings by 11 billion from 1999-2002
-Capitalized network maintenance and other costs that should've been charged to expense as incurred:
overstated both reported earnings and operating cash flow
-Understated allowance for doubtful accounts
What is meant by efficient securities markets - ANSWER-"An efficient securities market is one where the
prices of securities traded on that market reflect
all information that is known"
• Rational utility maximizers
• Prices reflect all available information that is known
• No one investor can "beat' the market unless stocks are under/overpriced by 'noise'
traders - no excess normal returns
• If information is incomplete, due to inside information, then stock prices will not reflect
true value
• Stock price efficiency does not reflect true value - market is not omniscient
• Unbiased and reacts quickly to new information - no serial correlation of prices (random
walk)
• Quality and quantity is enhanced by prompt and full reporting
• Individuals differ in prior beliefs
• These differences average out, so market has superior information to individuals
Accounting implications efficient securities markets - ANSWER-1. Accounting policies adopted by firms
do not affect their security prices, as long as these policies have no differential cash flow effects,
particular policies used are disclosed, and sufficient information is given so reader can convert across
different policies
2. Full disclosure goes hand and hand- disclose new info when benefits exceed costs
3. Accounting bridges the gap in true value by providing more inside information--accountants in
competition with other information providers
,4. Naive investors are protected by efficient markets. Naive investors can rely on experts, and if enough
informed investors trade, and naive investors can trust markets are efficient
If enough informed investors understand the disclosed information, market price is the same as if all
investors are informed
How is stock market response to an earnings announcement measured? - ANSWER-1. Measure a return
window (one month or one day)
2. Measure abnormal returns in order to separate market-wide and firm-specific factors
3. Measure unexpected earnings
4. Earnings response coefficient
Abnormal returns - ANSWER-Actual returns less expected returns
Expected returns based on - ANSWER-Market model such as CAPM, prior year's returns, actual returns
Unexpected earnings - ANSWER-Actual earnings - expected earnings
Expected earnings based on - ANSWER-Prior earnings or analysts./management forecasts
If response positive and statistically signifigant - ANSWER-Causality if short window: earnings cause a
stock market response
Association if long window: earnings associated with a stock market response
Earnings are relevant to investors
ERC implications: Growth, persistence, earnings quality, etc
Why does true net income not exist? - ANSWER-1. Lack of objective state probabilities
, 2. b. Equality of present values and market values under ideal conditions suggests an indirect approach
to true economic income—base the income calculation on changes in market values rather than present
values
i. Problem: market values need not exist for all firm assets and liabilities: incomplete markets
ii. Reasons for incompleteness: thin markets—oil and gas reserves; information asymmetry—too much
asymmetry, no market develops
c. If no market value, cannot use market value as proxy for present value
d. If you have to estimate present value, true net income does not exist
What is the fundamental problem of accounting theory and why does it exist? - ANSWER-i. How to
design and implement concepts and standards that best combine the investor-informing and manager-
performance evaluating roles for accounting information
ii. The best measure of net income to inform investors (control adverse selection) is not the same as the
best measure to control moral hazard (motivate manager performance)
Why is accounting information complex? - ANSWER-a. It is complex because the product of accounting is
information: a powerful and important commodity. Main reason for complexity: absence of perfect or
true accounting concepts and standards—individuals will not be unanimous in their reaction to even the
same information
What is efficient contracting? - ANSWER-b. The contracts the firm enters into (debt and managerial
compensation contracts) create a primary source of demand for accounting information—role of
accounting information is viewed as one helping to maximize contract efficiency or to aid in efficient
corporate governance (those firm policies that align the firm's activities with the interests of investors
and society)
Accounting policy implications of efficient contracting - ANSWER-i. Financial reporting should be reliable,
reliable reporting generates investor trust
ii. Financial reporting should be conservative—encourages stewardship (managers work in best interests
of firm owners)
1. Ex: Write assets down if CV < book value (lower of cost or market)—not reporting unrealized gains,
delaying recognition of income, prevents manager from increasing reputation and compensation by
increasing reported profits from unrealized gains
a. Provides an early warning to investors and creditors of impending losses, and avoid paying excess
dividends
Already answered| GRADED A+
WorldCom - ANSWER-Overstated earnings by 11 billion from 1999-2002
-Capitalized network maintenance and other costs that should've been charged to expense as incurred:
overstated both reported earnings and operating cash flow
-Understated allowance for doubtful accounts
What is meant by efficient securities markets - ANSWER-"An efficient securities market is one where the
prices of securities traded on that market reflect
all information that is known"
• Rational utility maximizers
• Prices reflect all available information that is known
• No one investor can "beat' the market unless stocks are under/overpriced by 'noise'
traders - no excess normal returns
• If information is incomplete, due to inside information, then stock prices will not reflect
true value
• Stock price efficiency does not reflect true value - market is not omniscient
• Unbiased and reacts quickly to new information - no serial correlation of prices (random
walk)
• Quality and quantity is enhanced by prompt and full reporting
• Individuals differ in prior beliefs
• These differences average out, so market has superior information to individuals
Accounting implications efficient securities markets - ANSWER-1. Accounting policies adopted by firms
do not affect their security prices, as long as these policies have no differential cash flow effects,
particular policies used are disclosed, and sufficient information is given so reader can convert across
different policies
2. Full disclosure goes hand and hand- disclose new info when benefits exceed costs
3. Accounting bridges the gap in true value by providing more inside information--accountants in
competition with other information providers
,4. Naive investors are protected by efficient markets. Naive investors can rely on experts, and if enough
informed investors trade, and naive investors can trust markets are efficient
If enough informed investors understand the disclosed information, market price is the same as if all
investors are informed
How is stock market response to an earnings announcement measured? - ANSWER-1. Measure a return
window (one month or one day)
2. Measure abnormal returns in order to separate market-wide and firm-specific factors
3. Measure unexpected earnings
4. Earnings response coefficient
Abnormal returns - ANSWER-Actual returns less expected returns
Expected returns based on - ANSWER-Market model such as CAPM, prior year's returns, actual returns
Unexpected earnings - ANSWER-Actual earnings - expected earnings
Expected earnings based on - ANSWER-Prior earnings or analysts./management forecasts
If response positive and statistically signifigant - ANSWER-Causality if short window: earnings cause a
stock market response
Association if long window: earnings associated with a stock market response
Earnings are relevant to investors
ERC implications: Growth, persistence, earnings quality, etc
Why does true net income not exist? - ANSWER-1. Lack of objective state probabilities
, 2. b. Equality of present values and market values under ideal conditions suggests an indirect approach
to true economic income—base the income calculation on changes in market values rather than present
values
i. Problem: market values need not exist for all firm assets and liabilities: incomplete markets
ii. Reasons for incompleteness: thin markets—oil and gas reserves; information asymmetry—too much
asymmetry, no market develops
c. If no market value, cannot use market value as proxy for present value
d. If you have to estimate present value, true net income does not exist
What is the fundamental problem of accounting theory and why does it exist? - ANSWER-i. How to
design and implement concepts and standards that best combine the investor-informing and manager-
performance evaluating roles for accounting information
ii. The best measure of net income to inform investors (control adverse selection) is not the same as the
best measure to control moral hazard (motivate manager performance)
Why is accounting information complex? - ANSWER-a. It is complex because the product of accounting is
information: a powerful and important commodity. Main reason for complexity: absence of perfect or
true accounting concepts and standards—individuals will not be unanimous in their reaction to even the
same information
What is efficient contracting? - ANSWER-b. The contracts the firm enters into (debt and managerial
compensation contracts) create a primary source of demand for accounting information—role of
accounting information is viewed as one helping to maximize contract efficiency or to aid in efficient
corporate governance (those firm policies that align the firm's activities with the interests of investors
and society)
Accounting policy implications of efficient contracting - ANSWER-i. Financial reporting should be reliable,
reliable reporting generates investor trust
ii. Financial reporting should be conservative—encourages stewardship (managers work in best interests
of firm owners)
1. Ex: Write assets down if CV < book value (lower of cost or market)—not reporting unrealized gains,
delaying recognition of income, prevents manager from increasing reputation and compensation by
increasing reported profits from unrealized gains
a. Provides an early warning to investors and creditors of impending losses, and avoid paying excess
dividends
