CHAPTER 6 SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

The following reasons for a measurement approach are suggested: It appears that historical cost-based net income explains only about 25% of the variability of share prices around the time of earnings announcement. This is Lev's (1989) "low R2" argument. Introducing more value-relevant information into the financial statements proper may increase earnings quality, assuming reasonable reliability, and thus increase the "market share" of net income. Evidence of efficient securities market anomalies suggests that investors need more help in interpreting supplemental disclosure than the information perspective has assumed. Incorporating more value-relevant information into the financial statements proper may be a way to do this. Perhaps the introduction of more value-relevant information into the financial statements will reduce auditors' legal liability, since the auditors can then better argue that the financial statements anticipated the changes in value that led to legal liability. This is particularly the case for overstatements of value. Overstatements can be reduced by conservative accounting in the financial statements proper, such as ceiling tests. Ohlson's clean surplus theory provides a theoretical framework supportive of a measurement perspective.

2.

Adoption of a measurement approach will increase the relevance of financial statement information. Relevant information is information that enables users to evaluate the firms future performance. The measurement approach implies the use of current values of assets and liabilities, such as market values (market

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price today is the best estimate of value tomorrow). Consequently, this perspective is more relevant than valuations based on historical cost. Assuming that well-working markets are available, a measurement approach should not reduce reliability. Market values are representationally faithful since a well-working market value represents the real value of the item being valued. Also, market values are difficult for managers to bias and are verifiable. However, if well-working market values are not available, estimates of fair value must be made, and such estimates imply lower reliability. The effect of the measurement perspective on decision usefulness thus depends on its relative effects on relevance and reliability. If the main diagonal probabilities of the information system increase due to higher relevance by more than they decrease due to lower reliability, decision usefulness of the financial statements proper will increase. 3. Post-announcement drift is the tendency for the share prices of firms that report GN or BN in quarterly earnings to drift upwards and downwards, respectively, for a lengthy period of time following the release of the earnings report. It is known that quarterly seasonal earnings changes are positively correlated. The reporting of, say, GN this quarter (compared with the same quarter last year) increases the probability of reporting GN next quarter as well. Thus, current quarterly earnings have two components of information content. One component is their information content per sethey provide current GN or BN that enables investors to revise their beliefs about future firm performance. Second, they increase the probability of GN or BN in future quarters, which will enable a further belief revision. This is an anomaly for efficient securities markets theory because, to the extent that the drift is not explained by barriers to arbitrage such as idiosyncratic risk or transactions costs, share prices should respond immediately to all the information content of earnings, according to the theory. However, this does not

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seem to happen. Instead, the market takes a lengthy period of time to figure this out or, alternatively, it waits until the current implications are validated in subsequent quarterly reports. Post announcement drift may or may not imply non-rational investors. On the one hand, it could be driven by behavioural biases such as conservatism or limited attention. On the other hand, it could be driven by the uncertainty of rational investors about whether the firms expected earning power has in fact increased (for GN) or decreased (for BN). In the face of this uncertainty, investors attach some probability to each possibility, and revise their probabilities over time as new evidence appears. These revisions will produce an upward or downward drift in share price over time. 4. The efficient market will respond more strongly to the GN or BN in earnings (i.e., a higher ERC) the greater is the persistence of the GN or BN. Cash flows are more persistent than accruals since the effects of accruals on current earnings reverse in future periods, whereas (operating) cash flows are not subject to this reversal phenomenon. Sloan checked this argument for his sample firms and found that cash flows were indeed more persistent than accruals. This being the case, the efficient market will respond more strongly to a dollar of abnormal earnings if it comes from operating cash flows than if it comes from accruals (recall that net income equals operating cash flows plus or minus net accruals). Sloan found that while the market did respond to the GN or BN in earnings, it did not respond more strongly when there was a greater proportion of cash flows to accruals in earnings. This is an anomaly because a differential response is predicted by efficient securities market theory. 5. According to rational single-person decision theory, the investor will prefer the first fund, since it has both a higher expected return and a lower risk. According to prospect theory, however, investors will separately evaluate gains and losses on their investment prospects, and the rate of decrease of utility for small losses may be considerably greater than the rate of increase of utility from
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small gains. Since the second fund truncates the fund losses, this gives it an advantage over the first fund. Also, under prospect theory, investors may underweight probabilities of states that are likely to happen, as a result of overconfidence bias, and overweight probabilities of states that are unlikely to happen, due to representativeness bias. The probability of a gain (a state realization) on the first fund is high relative to the probability of a gain on the second fund (due to higher expected return and lower standard deviation of the first fund. Thus, underweighting the high probability of a gain on the first fund and overweighting the low probability of a gain on the second fund tilts the decision towards the second fund. Thus, the choice of the second fund is due to either or both of a relatively high disutility for losses and weighting of probabilities. 6. a. Earnings quality, also called informativeness of the information system, is

the ability of current earnings to enable investors to infer future firm performance. It can be conceptualized by the main diagonal probabilities of the information system (Table 3-2). The higher the main diagonal probabilities relative to the offmain diagonal, the greater the quality. b. Except under ideal conditions, net income does not completely capture all

events affecting firm value for the following reasons: Historical cost-based accounting, still a major component of the mixed measurement model, lags in recognizing many value-relevant events such as management changes, new processes and patents, discovery of natural resources, production of inventory, etc. Thus, there are many factors affecting share price that the efficient market will recognize prior to financial statement recognition. Consequently, investors may not give full attention to reported earnings, preferring to rely on more timely information sources. The informativeness of price, particularly for large firms. Other sources of information, such as the media, company announcements, quarterly reports,

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are often more timely than earnings. Thus, the market will anticipate much of the information content of net income, leaving less for the market to react to at the earnings release date. The presence of liquidity or noise traders means that there are always random factors affecting share price. Net income would not be expected to explain these. Non-stationarity. Share price parameters such as beta may shift over time. This will affect share price but is not explained by net income. Non-rational investors. Investors subject to self-attribution bias may overreact to good news, leading to share price momentum, or underreact to bad news. Investors subject to limited attention may not process all available information. Both of these characteristics will reduce or delay share price reaction to net income. c. Increased use of a measurement perspective in financial statements will

raise earnings quality if the resulting increase in relevance outweighs the decrease in reliability. Relevance increases because there is less of a lag between the occurrence and recognition of value-relevant events such as changes in fair values of investments, capital assets, changes in the present value of long-term debt, pensions, post-retirement benefits, etc. Reliability will not decrease providing fair values are based on well-working market prices. However, to the extent such market values are not available, greater use of measurement may decrease representational faithfulness and verifiability, and increase possibility of bias. If the effect on relevance is greater than the effect on reliability, the main diagonal probabilities of the information system increase. That is, earnings quality increases. Then, we would see a larger response of security prices to the good or bad news in earnings (i.e., higher ERC). 7. From a single person decision theory perspective, reported earnings are value relevant if they lead to buy/sell decisions, caused by investors revising their beliefs about future firm performance, during a narrow window surrounding the
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date of release of the earnings information. Buy/sell decisions in turn lead to changes in share prices and returns. R2 measures value relevance of earnings information since it is the proportion of the variability of abnormal share return explained by the GN or BN in reported earnings during a narrow window surrounding the earnings release datethe higher is R2 the greater the value relevance of reported earnings since a greater proportion of the change in share price during the narrow window is then explained by the earnings information. ERC measures value relevance of earnings information since it is the amount of abnormal share return per dollar of earnings GN or BN. The higher is the ERC, the greater is the value relevance of reported earnings since a high ERC means that the earnings information has a high impact on investor buy/sell decisions. Note: The ERC is affected only by the reported earnings information. R 2 can fall even if the effect of earnings information on share price holds steady or increases, since a decrease in R2 can also be due to the effects on investor decisions of an increase in the information provided by factors other than reported earnings. This other information would be captured by the residual term of the returns/earnings regression. In this scenario, the fall in R2 is due to more share price variability to be explained, rather than necessarily to a decrease in the quality of earnings per se. Yes, it is possible for R2 and ERC to fall but abnormal return to increase if other firm-specific factors accompany the earnings announcement. Abnormal return includes the effects of all firm-specific factors affecting share price, while R2 and ERC capture only the effects of reported earnings. Other firm-specific factors which may accompany the earnings announcement include announcements and forward-looking information from company officials, information on unusual and non-recurring events, analysts comments, and media articles. This information will also affect buy/sell decisions. Thus it will affect abnormal return even though it may not affect R2 or ERC.

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8.

One reason is that the level of profits reported from the beat-the-market strategies seems too high to be explained solely by transactions costs. For example, Bernard and Thomas (1989) earned an average annual return of 18% over and above the return on the market from their post-announcement drift investment strategy. Excess returns are also reported by Sloan (1996). More fundamentally, there are no theories or models to predict what transactions costs should be. Lacking these, any level of profits could be claimed to be because of transactions costs, which clearly does not resolve the question of whether transactions costs solely explain the anomalies. Another argument against a transactions cost-based explanation of the anomalies is that large investors, including pension funds, mutual funds, financial institutions, may have the market clout, resources and expertise to lower transactions costs. The economies of scale that these investors may attain could enable them to engage in sophisticated investment strategies at relatively low cost. If the anomalies earn excess returns over the market even in the presence of these low-cost investors, the adequacy of a transactions cost-based anomalies explanation is further reduced. Finally, transactions costs are only one barrier to arbitrage. Another barrier is idiosyncratic risk. To fully explain efficient securities market anomalies, idiosyncratic risk must also be considered.

9.

Transactions costs. To the extent there are costs to exploit securities market efficiencies, investors will not fully eliminate share mispricing through arbitrage. This allows anomalies such as post-announcement drift and the accruals anomaly to continue. Idiosyncratic risk. To exploit market anomalies, investors must depart from a strategy of portfolio diversification. Then, firm specific risk becomes a larger component of the investment portfolio. Since risk averse investors trade off risk and return, increased risk inhibits their investments in mispriced securities. This allows the anomalies to continue.
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10.

a.

The information is potentially useful to investors since it emphasizes that

earnings do not augment firm value unless they exceed expected earnings, that is, earnings greater than the cost of capital used to earn them. This is consistent with the clean surplus Equation 6.1, where goodwill is the present value of future abnormal earnings. The EVA information may help investors to evaluate the goodwill component of firm value. A counter argument is that investors already have sufficient information (including cost of capital, which can be estimated from the CAPM, or by inverting the clean surplus formulasee last paragraph of Section 6.5.4) to calculate EVA for themselves. Given securities market efficiency, the information in the EVA would be incorporated into share price as soon as the current years earnings and financial statements were released. Thus, while it may serve as a convenience for investors who do not wish to make the calculations for themselves, the EVA adds little to the information possessed by the market. Since the firm may have a better estimate than the market of its cost of capital, a possible exception is that the market may obtain a better cost of capital estimate, assuming the firm discloses this rate in its capital charge calculations. The relevance of EVA is high or low depending on which of the foregoing arguments is accepted. With respect to reliability, the EVA information is similar in reliability to the financial statement information on which it is based. If capital employed and net operating profit are based on historical cost accounting, reliability would be relatively high. To the extent that they are based on current values, reliability may be lower, depending on the extent to which well-working market prices are used in the fair value calculations. b. EVA may discourage the top manager from initiating major capital

expenditures since these would carry with them an automatic capital charge. Even if the expected value of a project exceeds the capital charge, the manager

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may be discouraged if the project is risky. The riskier the project, the higher the probability that project earnings may dip below cost of capital at some point, resulting in a negative EVA. Of course, discouraging capital investment is not necessarily bad, since EVA puts managers on notice that new investment should earn at least its cost of capital. Thus, the discouragement would be primarily with respect to marginal and/or risky projects. c. Given that the intangible assets are not included in the capital base, the

effect would be to raise the reported EVA. As a result, the greater the proportion of unrecorded intangibles in firm value, the higher the EVA would have to be before it is interpreted as satisfactory. This is because unrecorded intangibles show up in reported earnings over time as their value is realized, not in the capital base. In clean surplus terms, they are part of abnormal earnings rather than part of the balance sheet. Another interpretative aspect is that to the extent intangibles are not included in the capital base, the firm may overinvest in expenditures that create unrecorded intangibles, such as R&D. Notes: For further discussion of these and other aspects of EVA, see also, Valuing Companies: a star to sail by, The Economist, August 2, 1997, pp. 53-55. Since amortization of purchased goodwill was removed from GAAP in 2001 in Canada and the U.S. and 2004 internationally (see Section 7.4.2), purchased goodwill is fully included in the capital base for EVA. Prior to 2001/2004, such goodwill was included in the capital base only to the extent it was not amortized. One can then raise the question of whether or not the elimination of amortization imposes greater discipline on managers of parent companies not to overpay for acquisitions.

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Instructors who wish to consider the accounting, or lack of accounting, for unrecorded intangible assets and its effects on reported earnings and EVA in greater depth may find the following suggestion of interest: Numerous authors have pointed out that the value of many firms, such as the high tech firms mentioned in part c, comes primarily from intangible rather than tangible assets. This raises questions about the adequacy of historical cost-based accounting for such firms. Intangible assets are seldom recorded, unless they have been purchased (see Section 7.4.2), despite the lack of relevance that ensues. The reason for not recording self-developed intangibles, presumably, is due to problems of reliability. In effect, the accountant throws up his/her hands and requires immediate writeoff of expenditures such as advertising, R&D, and employee training. As mentioned, intangibles do show up, but only as realized over time in the form of higher earnings and EVA. In this regard, The Economist, (June 6, 1998, p.64) contains an outline of a proposal by Edvinson and Malone (Leif Edvinson and Michael Malone, Intellectual Capital, Harper Business, 1997). To arrive at a value for total intangible assets (i.e., intellectual capital), these authors suggest that the fair value of net physical assets be deducted from the market value of the firm. Intellectual capital is then prorated into various components, such as human capital, patents and copyrights, etc. These values can then serve as the basis for a constructive debate as to whether the capital market has over or undervalued their real worth. However, this suggestion is unlikely to add much to what the market already knows about the value of intangible assets. The difference between the firms market value and the fair value of its net physical

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assets is the markets assessment of the value of its goodwill. The role of financial reporting is to add to what the market knows, not simply to reflect what it knows. There thus seems little scope for a constructive debate. d. Yes, it adds credibility. Domtars management would hardly be expected

to report voluntarily the rather bleak EVA this year if they did not expect to do better next year. In effect, reporting EVA this year puts their expectations for next year on the line. The market would realize that they must have plans to turn operations around. Note: Domtar did not do better in 1997, and its 1997 annual report contained only brief reference to EVA.

11.

According to clean surplus theory, the firms opening market value is:

PA1

Book value presentvalueof exp ected futureabnormalearnings (100 .14 500) 1.14 30 500 $526.32 1.14 500

Note: Many students answer this question as $500 + 100/1.14 = $587.72. This is incorrect as it ignores the fact that firm value consists of net assets as per the balance sheet plus the discounted present value of expected future abnormal earnings. Failure to deduct a capital charge overstates firm value, since the market expects the firm to earn its cost of capital on opening investment, and only values the abnormal portion of future earnings. To put this another way, the $500 book value of the firms assets would have to be written down if they could not earn cost of capital, according to ceiling test standards. 12. I have used this assignment on numerous occasions. Most students seem to enjoy it. I find that application of the recipe to value Canadian Tire Corp. in Section 6.5.3 is usually well done, although the instructor may assist students to
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evaluate the expected return on the market by discussing the concept of market risk premium described in Note 21 of this chapter. Stocks betas are usually available on the internetReuters and Yahoo Finance are good sources. If not, it is relatively straightforward to estimate beta directly, as I had to do for Canadian Tiresee Note 22. A complication is that many Canadian firms have a dual common share structuresee Note 23. While rather ad hoc, I suggest simply adding the number of shares of each class. The main problem students have with this assignment is to see beyond simply applying the procedure. Consequently, an important part of the assignment is to consider the effect of recognition lag, such as for R&D, on the calculations, and to consider the pattern and length of time that abnormal earnings are expected to persist. In my opinion, the main reason that the estimated share value is often less than the actual market share price is that the market has greater expectations about the amounts and duration of abnormal earnings than seems reasonable. I recommend discussing with the students (I do it after the graded assignment is handed back) issues surrounding the assumptions about abnormal earnings, although in an undergraduate course I do not go into the terminal value problem of estimating firm value beyond the specific earnings forecast horizon (I use a 7 year horizon for Canadian Tire). 13. Your decision is whether or not to go along with managements request. Reasons to go along: If you do not go along, you may suffer demotion or be fired, or be forced to resign. In contrast, if you go along, you will possibly earn managements approval and consequent rewards. Recognizing revenue early increases earnings relevance, since investors get an earlier reading on future firm performance. If business picks up next year, the early revenue recognition this year may never be noticed, since reduced revenue recognized next year (as current

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years revenue accruals reverse) will be outweighed by revenue from new business. Since GAAP requires considerable judgement in its application, other expert accountants and auditors may conclude that, despite your reservations, the extra revenue recognition does not really violate GAAP under the circumstances. If the auditor goes along with managements request, you can blame the auditor should the early revenue recognition be discovered. Reasons to not go along: Deliberate GAAP violation is unethical. If discovered, this will lower your reputation, the reputation of management and the company. Investors will lose confidence and share price will fall. If you go along, managements opinion of you may actually decline. You could be viewed as easily manipulated and of low standards. This would increase the likelihood of similar demands in future. Early revenue recognition lowers earnings reliability. There is a substantial probability that actual earnings on the contracts in process will differ from the amounts currently projected. Managements optimism may prove to be unfounded, and next years business may not pick up. This increases the probability that the early revenue recognition this year will be discovered. Should the auditor not go along, you, management, and the company will become involved in extensive arguments and negotiations with the auditor. This will be costly, time-consuming, and may lead to auditor resignation or a qualified audit report, with attendant bad publicity.

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14.

a.

An auditor might be tempted to cave in to client pressure to manage

earnings for the following reasons: GAAP are often vague and flexible about specific accounting procedures. For example, there is considerable flexibility with respect to revenue recognition, the useful life of capital assets, and provisions for future liabilities such as site restoration. Such procedures are subject to estimation errors and management bias, hence unreliable. While vagueness and flexibility can be used to report higher current earnings, this comes at the expense of earnings in subsequent years, since accruals reverse. Nevertheless, the auditor may feel that such tactics are acceptable if they do not violate the letter of GAAP. Efficient securities market theory implies that information in MD&A or in notes to the financial statements will be fully incorporated into share prices. Then, the auditor may feel he/she is off the hook if these contain information that allows the market to detect and evaluate earnings management policies in the financial statements proper. The auditor may feel that he/she will lose future audit and other business from the client firm if managements pressure is not accepted. Longer-run costs to the auditor who yields to client pressure include: Lawsuits, when vague and misleading information in the financial statements becomes known. Reduction in reputation, when vague and misleading information in the financial statements becomes known. Reduced public confidence in financial reporting, leading to a loss of business. Since audits will be perceived as less valuable by investors, firms in general will reduce the amount of auditing they engagewhy pay the same audit fees if the audit product is not as valuable?

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Reduced public confidence in financial reporting, leading to increased regulation such as Sarbanes/ Oxley (see Section 1.2). One result of such regulation is a reduction in the types of non-audit work the auditor can undertake for the audit client. Note: Increased regulation can also have benefits for the auditor. For example, a provision of the Sarbanes/Oxley Act is that management must certify the fairness of the financial statements, and must certify the adequacy of the companys internal controls over financial reporting. It is likely that management will want increased audit work, including examination of internal controls, before signing such a certification. Furthermore, the auditors ability to stand up to management is strengthened. This is due, for example to the requirements under the Act that the auditor reports to the audit committee rather than to management, and that the audit committee be composed of independent directors. In addition, the Act creates the Public Company Accounting Oversight Board. This agency has the power to set auditing standards and to inspect and discipline auditors of public companies. If it operates as it should, future reporting scandals and resulting lawsuits will be reduced. b. To the extent that current values are determined by fair value on properly

working markets, client pressure would likely be reduced, since it is difficult for management to manage or bias market prices. If current values are determined by means of value-in-use measures such as present value, client pressure would remain since numerous estimates are required. The auditor may have little alternative than to accept many of these estimates. Current values, including ceiling tests, are future oriented relative to historical cost values. Thus, declines in current values, which typically precede business failure, would be contained in the financial statements proper under the measurement approach. This would reduce auditor exposure to lawsuits since the auditor could claim that information predicting a business failure was

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explicitly disclosed, and thus less subject to being missed by investors with limited attention or other behavioural characteristics. c. Behavioural concepts leading to market overreaction to earnings

expectations include self-attribution bias, representativeness, and overconfidence. Self-attribution bias causes investors faith in their investment ability to rise following GN in earnings, leading to the purchase of more shares and development of share price momentum. Momentum is reinforced by positive feedback investors, who buy when share price starts to rise, and vice versa. Investors subject to representativeness assign too much weight to current evidence, such as earnings growth. Then, the market will overreact to GN in earnings. Overconfident investors overestimate the precision of information they collect themselves, such as financial statement information. Then, if the firm reports, say, BN they revise their probability of poor future firm performance by more than they should according to Bayes theorem. This leads to share price overreaction to the BN. Market overreaction to (negative) changes in earnings expectations is also predicted by prospect theory. Under this theory, a reduction in prospects for future earnings lowers investor utility by more than it is increased by a corresponding increase in prospects. Then, we would expect a relatively strong market reaction if earnings forecasts are not met. However, prospect theory also predicts that investors will tend to hold on to loser stocks. This would tend to reduce, rather than increase, market reaction to a reduction in earnings expectations. Thus, the extent to which investors probability weightings contribute to market overreaction under prospect theory is not clear. d. It is difficult to fully evaluate consistency with securities market efficiency

without information on the risk-free interest rate, Kodaks beta, and the performance of the market index on the day of Kodaks announcement. Share price did fall after the bad-news announcement, but we cannot tell whether or not
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the fall is more or less than what would be expected due to market-wide factors on that day. However, if we assume that market-wide effects were relatively small, note that analysts estimates of Kodaks earnings per share fell by .10/.90 = 11.1%. Kodaks share price fell by 9.25/(79. + 9.25) = 10.5%. Given that investors use current earnings to revise their probabilities of future earnings, hence of future firm performance, the reduction in Kodaks share price seems reasonable, hence not seriously inconsistent with securities market efficiency. However, share price subsequently rose by 2.25/73.12 = 3% following a .01/.80 = 1.25% excess of reported EPS over analysts estimates. This seems less consistent with efficient securities market theory. Note: These calculations ignore investors prior probabilities. For example, an investor with very low prior probabilities that Kodaks future performance will be low would not react as strongly to Kodaks earnings shortfall as an investor with very high prior probabilities of low performance. 15. a. The calculation of economic profit by TD is related to the estimation of firm

value under clean surplus theory since they both involve the deduction of a cost of capital charge from reported earnings, to arrive at abnormal earnings. They differ, however, in the time periods to which they apply. Under the TD economic profit approach, abnormal earnings are reported only for the current period. Under clean surplus theory, it is expected future abnormal earnings that are calculated. If an accurate estimate of goodwill and other intangibles was recorded on TDs balance sheet (unlikely, since GAAP does not allow the capitalization of self-developed goodwill, for example), there would be no future abnormal earnings (they are all capitalized on the balance sheet). Also, there would be no abnormal earnings in the current year. Since TD does report abnormal earnings for the current year, the relationship between its calculation and clean surplus is rather distant.

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Note: Some students may question the adding back of goodwill/amortization of intangibles to date to invested capital for purposes of the economic profit calculation. The likely reason for adding back goodwill/intangible amortization to date to invested capital is that that the bank regards income before amortization of goodwill and intangibles as better measuring bank performance. Thus it adds amortization back to economic income. But if goodwill and intangibles are not amortized, the cost of these items must be regarded as part of capital, for consistency. Note that only amortization of intangibles (i.e., not amortization of goodwill) is added back to economic income. This is because accounting standard setters have eliminated amortization of goodwill (Section 7.4.2). Thus there is only amortization of other intangibles charged against income in 2005. All previous intangible amortization is added back to capital, however. This addback includes goodwill amortized prior to the date of elimination of goodwill amortization. b. It is likely that TD has unrecorded goodwill. Its ability to earn more than its

cost of capital in 2005 suggests that it does. However, unrecorded goodwill exists only if future abnormal earnings are positive. TD has not estimated these. We may conclude that TD has unrecorded goodwill if it is able to continue earning more than its cost of capital. c. Either earnings number can be regarded as more useful. Arguments that net income is more useful include: Investors can estimate cost of capital and economic profit for themselves. They have no need for a second profitability measure.

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There is no GAAP for calculation of economic income. TD has added back amortization of intangibles to capital and added current years amortization and items of note to economic income. There is no guarantee that other firms reporting economic income would do the same thing. This affects the comparability of economic income across firms. One can question TDs assertion that items of note, such as losses on derivatives, preferred share redemption costs, etc. are not indicative of manager performance. Net income includes these items, and as such is a more comprehensive measure of management performance. The capital charge is based on the CAPM. This ignores estimation risk. Then, cost of capital is understated and economic income is overstated. This may give investors an exaggerated impression of TDs earning power. Economic income is similar in concept to EVA (see Question 10 of this chapter). Like EVA, it is subject to problems of interpretation if the firm has substantial unrecorded intangible assets. Arguments that economic income is more useful include: TD may have a better estimate of its own cost of capital than investors (although this seems unlikely since it is estimated using the CAPM). Then, economic income is useful because it improves the information available to the market. To the extent that investors have limited attention, economic income may be more useful since it removes the need for them to make their own calculations. As a result, such investors will have a better evaluation of firm performance than if only net income is reported.

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Items of note may have low persistence. Then, ignoring them may improve investors ability to predict future firm performance. Focussing on economic income, either construct may be argued as more useful: If economic income before intangible amortization and items of note is argued as more useful, a reason follows from managements view that intangible amortization and items of note do not reflect underlying bank performance. This suggests that management believes they are of low persistence. Since it is underlying performance that will largely determine the banks future earnings and share price, economic income before intangible amortization and items of note may be more useful to investors who wish to predict future firm performance. If economic income after intangible amortization and items of note is regarded as more useful, a reason is that intangible amortization and items of note are valid expense items and are likely to recur. For example, management has paid for goodwill and other intangibles arising from acquisition of subsidiary companies, and may well acquire other subsidiaries in future. Earnings should bear any resulting amortization and ceiling test writedown expense. Also, while the items of note may be of low persistence, similar items are likely to arise in future. Consequently, they should be taken into account when predicting future firm performance. 16. a. These events do not appear inconsistent with market efficiency. The

missing copper inventory and the overvaluation of restructuring costs and goodwill appear to have been inside information until revealed by the company in 1998. For example, the audited financial statements for 1995 and 1996 must not have mentioned these overstatements, nor did the unaudited information in the 1997 prospectus. Market efficiency is usually defined relative to publicly available information. When the information was made public, share price quickly fell. b. It is unlikely that fair value accounting would reduce the possibility of the

inventory overstatement in this episode. It was inventory quantity that was overstated, not an overvaluation of a correct quantity.
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c.

Ceiling tests may help to reduce auditor liability because they assist the

auditor to resist manager pressure to overstate assets, or to delay release of bad news that asset values have fallen below cost or amortized cost. Managers may argue that the firm intends to hold the assets to maturity and that current values are therefore not relevant. The auditor can better resist such manager pressure because ceiling tests are part of GAAP, which the ethical auditor cannot ignore. As a result, if the ceiling test is applied and the firm becomes financially distressed, it is less likely that assets will be found to have been overstated relative to their fair values. As the Deloitte & Touche settlement illustrates, auditors are frequently held liable for such overstatements.

Additional Problems 6A-1. On January 26, 1995, The Wall Street Journal reported that Compaq Computer Corp. posted record 1994 fourth-quarter results. Despite $20.5 million in losses from the December, 1993, Mexican currency devaluation, and losses on currency hedging, earnings grew to $0.90 per share from $0.58 in the same quarter of 1993, on a revenue growth of 48%. Furthermore, Compaq captured the No. 1 market share spot, with shipments up 50% from 1993 and with slightly higher profit margin. Nevertheless, on the same day, Compaqs share price fell by $5.00, a decline of about 12%. The Journal reported that analysts had been expecting earnings of about $0.95 per share. Also, there were concerns about Compaqs scheduled introduction of new products in March 1995, following a warning by Compaqs CEO Eckhard Feiffer that first-quarter, 1995 earnings were likely to be flat. Required a. Use single-person decision theory and efficient securities market theory to

explain why the market price fell.

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b.

Assume that the $20.5 million in losses from peso devaluation and

currency hedging are a provision (i.e., an accrual), not a realized cash loss, at the end of the fourth quarter. Use the anomalous securities market results of Sloan (1996) to explain why the market price fell. c. The Journal quoted an analyst as stating the market overreacted. Use

prospect theory to explain why the market might overreact to less-than-expected earnings news. d. Which of the above three explanations for the fall in Compaqs share price

do you find most reasonable? Explain.

6A-2. In the MD&A section of its 2000 Annual Report, Royal Bank of Canada reports economic profit. This consists of cash operating earnings less a capital charge of 13.5%, being the banks cost of common equity capital. The amounts for the last two years are as follows:

2000 Net income after preferred share dividends ($ millions) Add amortization of goodwill, other intangibles, and one-time items Cash operating earnings Capital charge Economic income Required a. Relate the concept of economic income here to the clean surplus 87 2,227 (1,460) $767 $2,140

1999 $1,600

168 1,768 (1,386) $382

valuation procedure in Example 6.2. Does Royal Bank have unrecorded goodwill? (No calculations needed.)

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b.

Royal Bank also breaks down results for its major business segments. For

example, the personal and commercial financial services segment contributed $469 million of the $767 total economic income for 2000. If you were the manager of a Royal Bank segment, would your propensity to incur large capital expenditures be affected by your knowledge that economic income was a factor in evaluating your performance? Explain why or why not. c. What new information, if any, is conveyed to the market by Royal Banks

disclosure of cash operating earnings and economic income? Why does Royal Bank make these disclosures?

Suggested Solutions to Additional Problems 6A-1. a. According to single person decision theory and efficient securities market

theory, the share price fell for one or more of the following reasons: Earnings came in below expectations of $.95 per share. This would cause investors to revise downwards their expectations of future earnings performance. Second, concerns about new products and the forecast of flat earnings would add to investors concerns about future earnings. Both of these effects would trigger sell decisions, driving down the share price. Beta may be non-stationary. Investors may have increased their perceptions of Compaqs beta risk. This would increase the expected return demanded by the market (see Equation 4.3), leading to a drop in the current share price (see Equation 4.2). b. The provision has a less persistent effect on earnings than a cash loss, since

accruals reverse. If so, the efficient market should react less negatively to the provision than to a realized cash loss. Sloans finding, however, was that the market did not make this distinction. Thus, the strong negative market reaction to Compaqs

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earnings could be explained as an anomalythe market reacted more strongly than it should have to the $20.5 million loss provision. c. According to prospect theory, investors overweight low probabilities and

underweight high ones. Assuming that the foreign currency losses and the failure to achieve expected earnings are rare events for Compaq, investors may overweight the low probability that they will recur and underweight the relatively high probability that operations will revert to normal levels. Furthermore, the lower-than-expected earnings creates a loss in value for investors. Under prospect theory, investors exhibit loss aversionthey react strongly to small losses (see Figure 6.2). Note: Loss aversion implies that investors will tend to hold on to loser stocks, however. If so, this would reduce, not increase, the downward pressure on Compaqs share price. All of these effects could explain the strong negative reaction. d. The chosen explanation is clearly a matter of judgement and preference. Any of

the explanations can be accepted as most reasonable providing that reasonable justification is given. Points to consider include: The efficiency explanation has considerable theory (i.e., single-person decision theory and the CAPM) behind it. Even the very volatile market response is consistent with the theory if we recognize that Compaqs beta may not be stationary. Then, rational investors may have different estimates of beta, causing them to react differently to the same information. This introduces additional volatility into the economy. Prospect theory also has a theory behind it. It is based on a behavioural view of human nature, in particular the concept of narrow framing, rather than a strictly economic view. This explanation would be favoured by those who believe that the securities market is driven by behavioural factors as well as economic ones,

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and is reinforced by the feeling of at least one analyst who stated that the market overreacted. Sloans findings are consistent with both a behavioural explanation and a rational investor explanation. Barriers to arbitrage, specifically transactions costs and idiosyncratic risk, prevent the anomaly from being quickly arbitraged away, although transactions costs are not a very satisfactory explanation without knowledge of what these transactions costs should be. Fama (Section 6.2.8) argues that alternative models to efficient securities markets have not yet explained the big picture. In effect, his argument is that the weight of empirical evidence still favours the rational economic view of securities price formation. 6A-2. a. Royal Banks concept of economic income is related to the clean surplus

valuation procedure through the concept of goodwill. Economic income shows the current instalment of the ability of the bank to earn a return greater than its cost of capital. Ability to earn an excess return on capital is the essence of goodwill. The clean surplus valuation procedure capitalizes the expected future stream of excess earnings. The Royal Banks procedure differs from the clean surplus procedure, however, since it applies to the current year, not to future years. Current years performance is already incorporated into the balance sheet under clean surplus. It seems, however, that Royal Bank does have unrecorded goodwill. If it did not, economic income (i.e., abnormal earnings) for the current year would be zero. This is because if all unrecorded intangibles were recorded on the balance sheet at their fair value, the bank would earn only its cost of capital on total net assets. b. Yes. I would thoroughly evaluate large capital expenditures. These would

be accepted only if there was a high probability of a return greater than the cost of capital. I would tend to avoid risky projects because if the expected high

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returns did not materialize my economic income would be negative. This would adversely affect my performance evaluation. c. Little, if any, new information is conveyed to the market by economic income. The market can estimate Royal Banks cost of capital and can make the economic income calculation for itself. There would be new information conveyed if Royal Banks cost of capital of 13.5% differed from the markets evaluation, and reflected inside information of management. Adding back goodwill amortization and other intangible and one-time items to determine cash operating earnings could assist the market in evaluating Royal Banks earnings persistence if these items were not fully disclosed in the financial statements. The bank may make the cash income and economic income disclosures because it feels that these earnings concepts better portray its results of operations. Alternatively, the bank may feel that amortization of (recorded) goodwill and other intangibles does not reflect its financial performance. Consequently, it adds these back to determine what it calls cash operating earnings. However, it may feel defensive about its high cash operating earnings, which seem high relative to its cost of capital, and may want to try to convince investors, and the public, that profitability should be measured after a capital charge. Since this produces a lower number, the bank may feel that concern about excessive bank profits will be reduced.

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