Q12-6

(A):
Why might a manager withhold bad news?

Cover up evidence of company shrinking, if the bad

news comes from low manager effort
Enable insider trading profits
Delay fall of share price, which can increase capital cost
and possibly affect managers compensation
Postpone reputational damage to the firm
(B):
When will the disclosure principle operate to
motivate the manager to report bad news?
Information can be ranked from good to bad in terms of its
impact on firm value
Investors know that managers have the information
No cost for the firm to release the information
Market forces and/or penalties in place to ensure the release
of truthful (credible) information
Should the information affects variables used for contracting
(can include share price or covenant ratios), releasing the
information do not impose cost increment on the firm
(B):
Under what conditions is the disclosure
principle subject to failure?
Information is proprietary
Unsure if the manager has the information
Accounting standards (or GAAP) quality is not too high
If releasing the information will cause more competitors
entering the market, then the firm will disclose some
information
If contracts are based on share price and releasing the
information will increase the firms contracting cost
(B):

Accou
nting
Unsure
Infor stand
if the
mati ards
manag
on is (or
er has
prop GAAP)
the
rieta qualit
inform
ry y is
ation
not
high
N New Inf
e s or
w will m
(B):

Contracts
are based
Releasing
in share
the
price and
informati
releasing
on may
the news
trigger
will
entry of
increase
competito
firms
rs
contracti
Conclusion:
ng costs
While disclosure
principle
Firm Not
has the in
will
potential firms
to motivate
Q13-4
(A):
In theory, what are the advantages of Employee
Stock Options (ESOs) as a compensation
device?
Alignment with Shareholder Interests
No Cash Outlay
No Effect on Net Income
Longer-Run Decision Horizon
Low Downside Risk
(A):

Alignmen No Cash
t with Outlay
Sharehold
er
Interests
Value Firms
of ESO not
depend require
ent on d to
share pay
price cash
as
(A):

No Longer Low
Effec Run Dow
t on Decision nsid
Net Horizon e
Inco Risk
me
B EMH- L
e Stron o
f g w
o would e
r mean s
e that t
2 inves v
0 tors al
(B):
In practice, during the period leading up to the
2007-2008 market meltdowns, what were the
claimed negative effects of the ESOs on
financial institution managers incentives and
actions?
Shortened Managers Decision Horizon
Opportunistic Manager Behaviour
Pressure to Meet Earnings Forecast
Excessive Risk Taking
(B):
Shortened Managers
Decision Horizon
Actions taken to
increase share price
in the SR to
maximise personal
gains
Opportunistic
Pump Behaviour
Manager and Dump -
Increase share
value
Spring before-
Loading
exercising options,
Pressuring
then sell the shares
compensation
before share
committees price
to grant
fell back, ESOs
unscheduled to
maximise
shortly before GNcash
(B):
Pressure to Meet
Earnings Forecast
Value of ESO is
dependent on share
price, which can be
greatly affected if
investors
Excessive Riskearnings
Taking
expectations are not
met
ESOs have low
downside
Managers riskmightand
resortupside
high to rewards
extreme
measures to
Managers inflate
stand to
reported
lose littleearnings
from any
risk-taking
behaviour that is
(C):

Are ESOs an expense? Explain why or why not.

ESO is an expense
Represents an
opportunity cost
Forgo
opportunity to
issue shares at
market price
Dilute
current
shareholder
s value
Value can be
(D):

With what theory of regulation are the claims of

opponents of the proposed standard most
consistent? With what theory are the FASBs
actions in implementing the new standard more
Opponents of
consistent? Explain your answers
proposed standard
Aligned with
interest group
theory
Proposed
standard results
in ESO
(D):
FASB - Aligned with
both theories
Public interest
theory
Aim to
maximize social
welfare
Expensing ESO
may reduce
negative effects
of ESO
Net profit better
represent true
performance of
firm
(E):
Suppose that you are a member of the FASB.
Evaluate a proposal to expense ESOs in relation
to the four criteria suggested in Section 13.5.
Decision Usefulness
Reduction of Information Asymmetry
Economic Consequences
Political Aspects
(E):

Decision usefulness
Relevance
Improved
relevance
Higher ESO
expenses is
an indicator
of lower
dividend
Reliability
Reduced
reliability
Fair value
model
(E):

Reduction of
information
asymmetry
Current standard
(2004) requires fair
value of ESO to be
stated in the Notes
to FS.
Evaluation for both
Information
Asymmetry
Reduction and
(E):

Economic
consequences
Costly to the firms
and managers
(Interest Group
Theory)
Greater
probability of
violating Debt
Covenants
Affects
Managers
Future Bonuses,
(E):

Political aspect
No agreement on
the proposed
standard for
expensing ESO
There are equally
powerful
proponents and
opponents of the
new standard
Result of the
Q13-8
Case Study:
Requirement for listed foreign companies in USA
to reconcile their FS from IASB to US GAAP
standards cancelled in 2007.
SEC is considering to allow US companies to
choose between US GAAP and IASB GAAP to
prepare their FS.
This results in competition between IASB and
FASB
Possibility of race to the top instead of race
(A):
What is meant by a race to the top in this
context?
It refers to each Standard Setting Body raising the
quality of its accounting standards, with the
expectation that firms will choose higher quality
standards for preparing financial statements
(B):
Assuming that Standard Setting Bodies wish to
maximise the number of firms using their
standards, why might a race to the top, rather
than a race to the bottom, result?
Higher quality information means lower estimation risk
for investors, hence it lowers cost of capital
Signalling effect. Firms that are committed to high
quality reporting will urge Standard Setters to raise
standards quality.
Higher quality reporting improves manager's
(C):
Given the SECs dropping of its reconciliation
requirement, what difficulties are created for
investors who wish to use financial statements
for investment decisions?

Without reconciliation, and in the absence of full

standards convergence, there will be an increase in
network externalities due to reduction in comparability
of financial statements. Thus, investors have to become
aware of the differences in the standards.
Even with convergence, investors must also be aware
that IASB standards may be applied differently by firms
Q13-19
(A):

Assuming that the goal of standard setters is to

ultimately value all assets and liabilities at fair
value, is the inclusion of unrealised gains and
losses in other comprehensive income most
consistent with the public interest or the
interest group theory of regulation? Explain.
(A):
Public interest vs Interest group theory
of regulation

Public Interest Theory = Regulators act in the

best interest for society
Interest Group Theory = Regulators act for
the most powerful interest group in helping
them retain power
(A):
Background :
1. Banks tend to dislike fair value accounting for
financial instruments. They dislike the volatility
that fair value accounting creates and the reduced
ability to manage earnings that results from fair
value accounting.
2. However, goal of standard setters prefer to value
all assets and liabilities at fair value.
Conclusion : Conflict of interest between both parties
(A):
Outcome :
IAS 39 contained several compromises to reduce
management concerns.
Inclusion of unrealized gains and losses on
available-for-sale financial instruments and fair
value hedges in other comprehensive income
Cost-based accounting for held-to-maturity
financial instruments
Fair value option
(B):
Under the original 1997 FASB accounting
standard (SFAS 130), OCI could be reported
either in a combined comprehensive income
statement or as part of a statement of changes
in shareholders equity. This latter option
shows OCI apart from net income. Most U.S.
Combined
firms Part of a
choose this latter option. Why?
Comprehensi OCI Statement of
ve Changes in
Income Shareholders
Statement Equity
(B):
First, we need to understand management attitude
towards disclosure of unrealised gains and/or losses.
Dislike to disclose unrealised gains and losses that
are in OCI
Therefore, firms like to report OCI apart from net
income because:
1. It would be further from the eyes of the investor
2. Less noticeable when it is hidden in the
statement of changes of equity
(C):
Is inclusion of OCI in a separate statement of
changes in shareholders equity consistent with
managers acceptance of efficient securities
market theory? Explain.
Not consistent.
Under the Efficient Securities Market Theory, all publicly
available information will fully reflect the fundamental
value of a firms share at all times.
Hence, the market will evaluate OCI information
regardless of its location in the Financial Statements.