Question 1 (17 marks)

HiSpeed Ltd. plans to manufacture cross-country skiing equipment. Its cash flows are highly dependent on the weather in early winter. HiSpeed operates under ideal conditions of uncertainty. On August 1, 2014, the beginning of its first year in business, HiSpeed acquires equipment to be used in its operations. The equipment will last two years, at which time its salvage value will be zero. The company finances the equipment purchase by issuing common shares.

HiSpeed’s annual net cash flows will be \$800 if the weather is snowy and \$300 if it is not snowy. Assume that cash flows are received at year end. In each year, the objective probability that the weather is snowy is 0.7 and 0.3 that it is not snowy. The interest rate in the economy is 3% in both years.

HiSpeed will pay a dividend of \$50 at the end of each year of operation.

Required

a.     (9 marks)

In 2014, the weather is snowy. Prepare a statement of financial position as at July 31, 2015, the end of HiSpeed’s first year of operations, and an income statement for the year.

b.     (2 marks)

What timing of revenue recognition is implicit in the income statement you have prepared in part (a)? When ideal conditions do not hold, is this timing of revenue recognition relevant? Is it reliable? Explain.

c.     (6 marks)

Assume that HiSpeed paid the present value you calculated in part (a) for its equipment. Calculate HiSpeed’s net income for the year ended July 31, 2015 on a historical cost basis, assuming that equipment is depreciated on a straight-line basis. Under the more realistic assumption that ideal conditions do not hold, which measure of net income is most relevant? Which is most reliable? Why?

Question 2 (18 marks)

Prem has \$2,000 that he wishes to invest for one year. He has narrowed his choices down to one of the following two actions:

i: Buy bonds of X Ltd., a company that has a very high debt-to-equity ratio. These bonds pay 8% interest, unless X defaults, in which case Prem will receive no interest but will recover his principal. (a 1)

Prem assesses the prior probability of X Ltd. defaulting as 0.40. His utility for money is given by the square root of the amount of his net payoff. That is, if he buys the Canada Savings Bonds, his net payoff is \$60, yielding utility of √60 = 7.75, and so on. Prem is a rational decision maker.

Required

a.     (4 marks)

Based on his prior probability calculations, which action should Prem take? Show your calculations.

b.     (9 marks)

Before making a final decision, Prem decides he needs more information. He obtains X Ltd.’s current financial statements and examines its times-interest-earned ratio. This ratio can be either high or low. Upon calculating the ratio, Prem observes that it is low. On the basis of his prior experience in bond investments, Prem knows the following conditional probabilities:

 Debt-to-Equity Ratio Future State Low High ND (no default) 0.50 0.50 D (default) 0.05 0.95

Which action should Prem take based on this new information? Show your calculations; take each step to two decimal places.

c.     (5 marks)

An accounting standard (IAS 16) allows X Ltd. to value its property, plant, and equipment at fair value. The company plans to adopt this option, since it will reduce its debt-to-equity ratio.

Evaluate (in words — no calculations required) the likely impact of this adoption on the main diagonal probabilities of the information system in part (b).

Question 3 (15 marks)

Efficient securities market theory has long been under attack from behavioural finance, which draws on behavioural theories of investor behaviour to explain why security prices do not always behave as the economic theories of rational investing and market efficiency predict. These attacks have increased since the 2007-2008 security market meltdowns.

Required

a.     (4 marks)

Explain why prospect theory predicts that security prices will differ from their prices under efficient security markets theory.

b.     (4 marks)

Describe two accounting-related efficient securities market anomalies and, for each, explain why it is an anomaly.

c.     (3 marks)

The efficient securities market anomalies suggest that investors underreact to the full information content of financial statements. Choose one behavioural theory that predicts this underreaction and explain  why it predicts underreaction.

d.     (4 marks)

Should accountants be concerned that the importance of financial reporting may decline if behaviourally biased investors do not use all the information in the financial statements? Explain.

## Assignment 2 — Session 2 (Winter)

This assignment is based on Modules  1 through  7 and is due at the end of Module  7. It is worth  10% of your final course grade.

Refer to the general instructions in Assignment 1.

### Question 1 (20 marks)

Empirical tests of the three hypotheses of positive accounting theory (PAT) are often based on the amount of discretionary accruals contained in net income.

#### Required

a.     (4 marks)

What are discretionary accruals? Why are they useful in testing the three PAT hypotheses?

b.     (5 marks)

The methodology designed by Jones (1991) (called the Jones Model) is usually used to estimate discretionary accruals. Outline in words how the Jones Model measures discretionary accruals.

c.     (4 marks)

For good corporate governance, contracts should be designed efficiently. A researcher finds, for a sample of firms, that the covenant slack in debt contracts (the difference between the critical value of a debt covenant ratio as specified in a debt contract and the value of that ratio on the borrower’s books on the date of the contract) is greater on average with greater variability over time of the debt covenant ratios. Is this finding evidence of efficient or opportunistic contracting? Explain your answer.

d.     (7 marks)

Discretionary accruals can be used opportunistically or efficiently. Conservative accounting can be regarded as a form of discretionary accruals because the firm chooses to report (that is, accrue) lower asset values and/or higher liability values. A researcher finds that firms with income escalator clauses in their debt contracts (an escalator clause increases the covenant level of net worth the firm is required to maintain under the contract by a percentage of reported net income) tend to use more conservative accounting than similar firms with no escalator clauses in their debt contracts. Is this finding consistent with efficient or opportunistic contracting? Explain your answer.

### Question 2 (20 marks)

Several accounting standards include ceiling tests (also called impairment tests).

#### Required

a.     (6 marks)

What is a ceiling test? Identify two IASB accounting standards that contain a ceiling test and describe the test.

b.     (6 marks)

Ceiling tests are usually regarded in this course as one-sided examples of the measurement approach. However, they can also be regarded as examples of conservative accounting, as assets are written down but not written up. Ceiling tests are an example of conservative accounting. Why do bondholders favour ceiling tests? How do bondholders reward the firm for conservative accounting such as ceiling tests?

c.     (4 marks)

Explain briefly why auditors favour ceiling tests.

d.     (4 marks)

Outline the accounting for research and development (R&D) under IASB standards. Is this accounting conservative? Why? Explain why accountants account for R&D as they do.

### Question 3 (22 marks)

New Century Financial Corp., formed in 1995, was a large mortgage lender in the United States. Many of these mortgages were securitized and transferred to investors. New Century accounted for the proceeds of these securitizations as sales. However, New Century committed to buy back mortgages that became troubled within up to a year after transfer.

New Century would retain some mortgages for itself (called retained interests), from which it would receive future cash flows. Also, the transfer agreements included the right to service the mortgages, for which New Century charged a fee. New Century valued these retained interests and servicing rights at current value, based on their discounted expected future cash flows. Thus, revenue from retained interests was recognized at the time of retention, and servicing revenue was recognized at the time of mortgage transfer. These policies required numerous estimates, and contrasted with a more conservative policy of recognizing revenues as cash flows from retained interests were received and servicing responsibilities rendered.

The company’s share price increased dramatically, to a high of US\$64 in 2004. Its reported net income reached \$1.4 billion in 2005.

However, New Century seriously underestimated the extent of its mortgage buybacks and resulting credit losses. Of \$40 billion of mortgages granted in the first three quarters of 2006, it provided only \$13.9 million for buybacks. Investor concerns about increasing buybacks rose in 2006 as the 2007-2008 market meltdowns approached. These buyback concerns added to concerns about early revenue recognition from retained interests and servicing. Also, the company failed to write down its retained interests as the current value of the underlying mortgages decreased.

New Century was soon unable to borrow money to finance mortgage buybacks. Its shares lost 90% of their value, and the company was delisted from the New York Stock Exchange. In April 2007, it filed for bankruptcy protection.

New Century’s auditor (KPMG) was drawn into the lawsuits that followed. KPMG denied liability, claiming that the provisions for buybacks were deemed adequate at the time, and blaming New Century’s failure on the market meltdowns of 2007-2008. In December 2009, the SEC filed civil fraud charges against three former executives of New Century, seeking damages and return of bonuses. Several other lawsuits followed. In November 2010, financial media reported final settlement of a class action lawsuit that included a payment of over \$65 million by former company officers and directors, and a payment of \$44.75 million by auditor KPMG.

#### Required

a.     (4 marks)

Use the concept of relevance to defend New Century’s policy of recognizing revenue as it securitized and sold mortgages. What was the policy’s major weakness?

b.     (4 marks)

Outline a more conservative accounting policy for New Century’s mortgage sale transactions. Consider both statement of financial position and net income effects of your policy.

Hint: Read Theory in Practice 8.3, text page 314.

c.     (6 marks)

Use two characteristics of investor behaviour based on psychology to explain the rapid rise in New Century’s share price. Be sure to identify the specific behavioural characteristics you draw on in your answer.

d.     (4 marks)

Despite your answer in part (c), is the rapid rise in New Century’s share price necessarily inconsistent with (semi-strong) securities market efficiency? Explain.

e.     (4 marks)

Note that retained interests meet the definition of a financial instrument. How would these financial instruments be accounted for under IAS 39?

### Question 4 (18 marks)

Paul owns and operates a small, fast-growing business. He decides to hire a full-time manager. He will then take a year off to travel, and on his return will concentrate on the technical aspects of the business.

Martha applies for the job. During her interview, Paul finds that Martha is risk averse, with utility for money equal to the square root of the dollar compensation received. She has reservation utility of 6 and is effort averse, with disutility of effort of 2 if she works hard (a 1), and 1 if she does not work hard (a 2).

Paul’s business has, in previous years, earned net income before manager compensation of \$800 75% of the time, and income of \$0 25% of the time. Paul has taken courses in accounting and has always prepared the financial statements himself. Paul has always worked hard, and reckons that if he did not work hard net income would have been \$800 only 20% of the time and \$0 80% of the time. He expects this earnings pattern to continue into the future with a new manager. Paul realizes that he must motivate Martha to work hard, and offers her a one-year contract, with compensation based on a proportion of net income before manager compensation.

Note: Take all calculations to two decimal places.

#### Required

a.     (6 marks)

What proportion of net income must Paul offer Martha so that she will accept the position and work hard? Show calculations.

b.     (8 marks)

Assuming that Martha accepts Paul’s offer from part (a), show calculations that verify she will in fact be motivated to work hard.

c.     (4 marks)

Paul realizes that he cannot observe his firm’s unmanaged net income — he can only observe the net income Martha reports. He is concerned that Martha will opportunistically manage earnings while he is away to report net income of \$800 while not working hard. Suggest to Paul how he can reduce the likelihood that Martha will do this in a one-year contract.

### Question 5 (20 marks)

Most firms hedge at least some of their risks. Hedging can take two basic forms, namely natural hedging and hedging by means of derivative instruments. The use of derivatives as hedges has expanded greatly in recent years.

Generally, under accounting standards (IAS 39 and related U.S. standards), derivative instruments are fair valued with any unrealized gain or loss included in net income. However, hedge accounting provides some exceptions to this rule.

#### Required

a.     (4 marks)

A firm has a large amount of long-term debt (valued on a cost basis), and decides to set up a natural hedge of this debt. However, a natural hedge can lead to excess net income volatility, that is, net income volatility greater than the actual volatility of the firm’s operations. Explain how this can happen.

b.     (6 marks)

Suggest two ways that the excess net income volatility arising in part (a) can be prevented.

c.     (6 marks)

IAS 39 identifies two basic types of hedge. Describe each type. For each type, explain how IAS 39 controls excess net income volatility arising from entering into the hedge.

d.     (4 marks)

Use the bonus plan hypothesis of positive accounting theory to explain why a firm manager dislikes excess net income volatility. Are the policies to control excess net income volatility you described in parts (a) and (b) unethical? Explain why or why not.

## Assignment 3 — Session 2 (Winter)

This assignment is based on Modules  1 through  9 and is due at the end of Module  9. It is worth  5% of your final course grade.

Refer to the general instructions in Assignment 1.

### Question 1 (14 marks)

In July 2011, financial media reported that Glencore International, plc, a large, Swiss-based multinational producer of metals, energy, and agricultural commodities, had decided to stop reporting quarterly financial results from the second quarter of 2011. Glencore’s first-quarter 2011 sales and earnings were sharply higher than they were for the same quarter of the previous year, but it appeared that earnings for the first quarter still fell short of market expectations.

#### Required

a.     (4 marks)

Outline two possible reasons why Glencore reduced its information production in this manner.

b.     (4 marks)

How do you predict that the stock market will react to this decision by Glencore? Explain.

c.     (6 marks)

The covenants in Glencore’s debt contract required the company to report quarterly. To overcome the rigidity inherent in debt contracts, Glencore offered to make a cash payment to consenting bondholders of 0.25% of their holdings, up to a maximum of \$2.4 million, if they agreed to drop the covenant. If you were a Glencore bondholder, would you accept Glencore’s offer or not? Explain your reasons.

### Question 2 (18 marks)

Income smoothing is a common earnings management pattern. Many managers feel that their reputations, and their firms’ share prices, are enhanced by a smooth, steadily growing sequence of reported earnings.

#### Required

a.     (4 marks)

A behaviourally biased investor observes a firm’s earnings increasing steadily over time. The investor decides that this firm is a growth firm. Identify the specific behavioural bias that may underlie this investor behaviour and explain why it leads to identifying the firm as a growth firm. Is the investor necessarily correct in this identification as a growth firm? Explain why or why not.

b.     (4 marks)

Some firms have used low-persistence accruals to smooth net income to a level that the firm’s managers felt would persist. Is this type of earnings management good or bad in terms of usefulness to equity investors?

Does such smoothing benefit the manager whose compensation depends on reported net income? Explain why or why not.

c.     (5 marks)

A researcher finds that firms that are growing rapidly have, on average, a lower proportion of manager compensation based on net income, relative to share-based compensation, than firms that are not growing rapidly. Explain why. Use concepts of recognition lag, sensitivity, and precision in your answer.

d.     (5 marks)

A firm that has smoothed earnings for many years needs to manage its earnings upwards this year to maintain the pattern of smooth, steady earnings that it has been reporting. The firm anticipates a period of lower earnings next year. Would the firm manager be wise to smooth earnings this year? Explain why or why not.

### Question 3 (18 marks)

In January 2011, the U.S. Securities and Exchange Commission (SEC) adopted a requirement that companies give shareholders a “say on pay” of senior management. This requirement is part of the implementation of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, passed by the U.S. congress in response to the 2007-2008 market meltdowns, including widespread concerns that senior managers were overpaid. Shareholders will be asked to vote on executive compensation packages at least once every three years. The result of the vote is non-binding on the company. Results of the shareholder vote must be publicly disclosed.

In Canada, the Ontario Securities Commission is considering similar requirements.

#### Required

a.     (2 marks)

With what theory of executive compensation is say on pay most consistent? Explain.

b.     (6 marks)

The SEC is proposing that the compensation committee of the board of directors must consist of members independent of management. Also, the committee will have full authority to retain consultants, lawyers, and other advisors. Would such proposals, if implemented, eliminate the need for giving shareholders a say on pay? Explain.

c.     (4 marks)

The expected utility of compensation to a manager can be much less than the sum of dollar compensation, share, and option awards. Explain why.

d.     (6 marks)

Do you think the “say on pay” requirements and implementation of the SEC proposals on compensation committee member independence and freedom to hire advisors will be effective in increasing the efficiency of executive compensation contracts? Explain. Define a (second-best) efficient compensation contract as part of your answer.

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