Chapter 8: Usefulness of Accounting Information to Investors and Creditors

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CHAPTER HIGHLIGHTS
Chapter 8 is concerned with the usefulness of external accounting reports for decision making. The FASB emphasizes decision usefulness in both the conceptual framework project and in policy deliberations for specific standards. It focuses on the primary user groups, investors and creditors. Earnings, dividends, and stock prices are inextricably linked. Dividends are the cash flows that investors receive from dividend paying stocks. Managers think of cash dividends as being paid out of earnings. As such, the dividend discount model is equivalent to an earnings model. Predictive value is a major argument for the relevance of accounting information, and earnings appear to have value in predicting future dividends. Since the value of a stock is equal to the present value of the expected future dividends, earnings can be seen to play an important role in stock price valuation. Residual income models take a variety of forms. Regardless of form, residual income is the income generated in excess of that which was expected, given the amount of capital invested and the cost of that capital. Residual income is often used for valuation purposes and for determining compensation for management. With clean surplus accounting, residual income is equivalent to the dividend discount model. However, by incorporating non-accounting information, the residual income model allows investors to improve forecast accuracy. There are advantages and disadvantages to residual income models. Empirically, the jury is still out as to their usefulness. The efficient-markets hypothesis (EMH) states that capital markets fully and instantaneously reflect new information in security prices. If the hypothesis is correct, the value of new information is fully and completely demonstrated via the securitys price response. When this occurs, the item of information is said to have information content. The usefulness of accounting information to investors has been empirically investigated through tests of association between publicly released accounting data and changes in security prices. If there is a significant association, then there is evidence that accounting information is useful with respect to firm valuation. These studies also constitute tests of the efficient-markets hypothesis. Capital market research dominates the empirical literature. This is appropriate given its influence over the past 25 years. Other research is important, though it suffers from some methodological problems such as reliability (surveys) and lack of generality (experimental research). It is increasingly clear that, in practice, there are limitations of the efficiency of capital markets. This realization arises in relation to post-earnings-announcement drift, which has been determined from empirical research and the incomplete revelation hypothesis which is a deductive hypothesis. The empirical studies reviewed demonstrate that the market is not as efficient as we might have previously thought, or as efficient as we would like to believe. This suggests that there is value in putting time and effort into improving accounting standards.

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Capital markets research in accounting provides a basis for evaluating the present usefulness of accounting. Furthermore, the research methods themselves represent techniques and approaches that may be applied in an ongoing way to assess the usefulness of future or alternative accounting policies. This is particularly true for event studies, the mechanics of which are briefly discussed. While benefits are the focus of the chapter, questions of costs and the apportionment of costs are equally important. Some of the recent capital market research has focused on questions of how accounting policies affect owner wealth. These studies are often cast in terms of agency theory, and consider the costs of accounting policy changes in terms of their wealth impact on owners. However, the evidence on economic consequences is largely one-sided, focusing on benefits (e.g., information content) rather than costs. This point should be emphasized and related back to the question of determining optimal regulation. Finally, we note that accounting information is useful to creditors in evaluating default risk and predicting bankruptcy.

QUESTIONS
Q-1 How is accounting data useful to investors? To creditors? The financial economics valuation models reviewed in the chapter suggest that accounting reports are useful in assessing a firms future cash flows. This is consistent with SFAC No. 1, which views the role of accounting reports as aiding in assessing the amounts, timing, and uncertainty of prospective cash flows. Beavers work, while similar in spirit, sees the linkage as less directcurrent earnings predict future earnings, which in turn determine dividend-paying ability. The difference is that the former view sees a firms value as a function of future cash flows, and the latter sees it as a function of future expected dividends. Theory is less well developed with respect to the valuation of debt and the role of accounting information. The work reviewed in the chapter indicates that debt interest rates reflect a risk premium for the possibility of default. Therefore, the usefulness of accounting lies in aiding creditors to assess the likelihood of default. In very broad terms, this concern leads to an interest in future cash flows, viz., debt-servicing ability and the ability to repay or refund the principal amount of the debt. Hence, information to investors and creditors is complementary. Finally, both would be interested in accountability aspects of financial statements. Q-2 In what ways do you think information useful for investors (in assessing future cash flows) differs from that useful for creditors (in assessing default risk)?

In general, investors and creditors are interested in the amounts, timing, and uncertainties of a firm's expected future cash flows. Cash payments to equity holders are theoretically unlimited, and the focus is typically on the upside potential of the expected future cash flows. In contrast, the cash payment for debt securities is fixed by contract. Hence, the usefulness of accounting information for creditors lies in its ability to predict the failure of a borrower to make timely payment of interest and principal. Furthermore, the likelihood of default affects the 7th edition

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default risk premium, which in turn affects the rate the borrower is charged. Finally, we note that interest bearing debt securities trade infrequently. As a result, theories underlying the usefulness of accounting information to creditors are not as well developed as they are for equity securities. Q-3 Besides the primary investorcreditor group, what other user groups could claim to be stakeholders in the firm? How might their information needs be the same as the primary investorcreditor group? How might their information needs differ?

Any individual or entity whose income or payments are affected by a firm's financial wellbeing has stake in the firm. This would include taxing authorities, utility ratepayers, suppliers of materials and services, and even current or potential employees. To varying degrees, all of these stakeholders have an interest in forecasting the expected future cash flows, and in assessing the firm's financial wellbeing. Their respective information needs depend on the nature of the explicit or implicit contract. For example, income taxing authorities have a lot in common with shareholders; their receipts are more directly related to the firm's performance. In contrast, employees or utility rate payers, at least in the short-term, have contracts that provide for fixed receipts or rate payments. As such, the needs of these individuals might more closely be related to creditors. Q-4 Who are creditors?

Creditors are mainly considered suppliers of materials, services, or capital. They need financial information about their customers to determine the terms of credit. Q-5 Why do we sometimes say that the dividend discount model is actually an earnings model? How do Lintners findings relate dividends and earnings?

The dividend discount model is a mathematical model that expresses the value of a stock as the present value of the expected future dividends. Since dividends are considered to be paid from earnings, the dividend discount model can be rearranged to express the value of a stock in terms of the expected future earnings per share and the dividend payout ratio. Lintner interviewed a number of managers regarding how the managers make a decision regarding the payment of a cash dividend. Managers indicated that major changes in "permanent" earnings were the most important determinants of the companies' dividend decisions. Managers adjusted dividends to reflect expected changes in "permanent" earnings. Given the seriousness and forward-looking nature of the dividend policy decision, investors regard cash dividends as credible signals of future performance. A change in the cash dividend has information content. Q-6 What is residual income? Abnormal earnings? Economic profit? EVA?

Residual income is a general term for income in excess of a charge for the capital employed to generate that income. The concept may be applied to the enterprise as a whole or to the firms common equity. When applied to the enterprises operating income and invested capital, residual income is often called economic profit or Economic Value Added (EVA). When applied to the firms net income and common equity, residual income is often called residual income or abnormal earnings. 7th edition Page 3 of 16

Chapter 8: Usefulness of Accounting Information to Investors and Creditors Q-7 How does EVA differ from economic profit?

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Economic Value Added (EVA) is a proprietary form of economic profit developed by Stern Stewart & Co. EVA begins with residual income [economic profit] and makes a series of additional adjustments to GAAP accounting that are intended to produce a "better" estimate of economic profit. Q-8 What are some advantages and disadvantages of using residual income (including economic profit and EVA) for performance measurement?

On the positive side, residual income can be used as a company and intra-company performance measurement tool. It recognizes that capital has a cost. Making capital an explicit part of the model raises the awareness of using excess capital to generate income; capital has a cost. In addition, residual income has been shown to have more explanatory power than reported earnings or cash flow from operations. It can also be used for valuation purposes. On the negative side, for any given year, the determination of the residual income itself is dependent on an accurate estimate of the cost of capital. And for valuation purposes, forecasts are crucial. All forms of residual income are consistent with discounted net cash flows for any book value and any method of depreciation. Lengthening the depreciable life for fixed assets decreases the per-period depreciation expense, increases NOPAT, and increases the residual income. In some cases, it may not be possible to determine whether the residual income calculated is actually due to managements efforts or lack thereof. Residual income is an accounting measure and can be manipulated for any one period. Furthermore, if improperly applied, residual income could bias management against long-term investments. Unlike the stock price, which is forward looking, residual income focuses on historical performance. Finally, it is not clear that residual income leads to improved stock performance. Q-9 Comment on the following statement: The residual income model is no different from the dividend discount model. Therefore, it has no value to investors and analysts.

The residual income model is consistent with the dividend discount model. However, this does not mean that it has no value. As indicated above, it can be used as a performance measurement tool. Unlike net income, residual income recognizes that capital has a cost. Furthermore, residual income has been shown to have more explanatory power than reported earnings or cash flow from operations. Finally, Dechow, Hutton and Sloan have shown that the residual income model allows the user to incorporate non-accounting information into the model to improve its accuracy. Q-10 Comment on the following: Maximizing residual income is the same as maximizing earnings. Managers should be rewarded for maximizing either one.

Managers can increase earnings by increasing the amount of capital employed. On average, investing in more assets translates to increased earnings. The problem is that there is no 7th edition

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guarantee that the additional capital employed is earning its cost of capital. If not, deploying additional capital is destroying shareholder wealth, similar to investing another $1.00 to gain an additional $0.80 of intrinsic value. In contrast, residual income explicitly recognizes that capital has a cost. Managers can only increase value if they increase income above and beyond that which is required for the amount of capital employed. Managers should not be rewarded for maximizing earnings if the capital employed is not earning its cost of capital. Q-11 Why do managers of Berkshire Hathaway have an incentive to send cash to Omaha?

Managers at Berkshire Hathaway are charged a high rate for the incremental capital that they employ. If they can generate income in excess of that capital charge, they create value and are rewarded. If not, they destroy value, and are penalized accordingly. Implicitly, this is an application of residual income model. If managers are not able to use the incremental capital to create value, they have a strong incentive to lower their invested capital and capital charge by sending the cash to Omaha (Warran Buffett). This lowers or eliminates any penalty. Cash that cannot be profitably invested is given to Warren Buffett who distributes it to the individuals who are best able to invest it. Q-12 Should firms capitalize research and development expenditures? Why or why not?

Research and development expenditures are cash outflows. If they are expected to generate future income, one can make an argument that these expenditures are really investments, which should be capitalized. This is exactly what is done when firms use EVA. The problem is that there is less certainty about future income from R&D than there typically is with investments in other tangible assets. In the worst case, one can easily envision a case in which a firm capitalizes worthless R&D in order to lower operating expenses and increase reported income. Q-13 What is clean surplus accounting? What is its role in linking dividends and abnormal earnings?

Clean surplus accounting is a term indicating that all profit and loss elements go through income. It relates the current book equity to previous book equity, earnings, and dividends. In the presence of clean surplus accounting, the residual income model is equivalent to the dividend discount model. Q-14 What is the efficient-markets hypothesis?

In its simplest form, the efficient-markets hypothesis states that information is quickly impounded in security prices. Market efficiency refers to informational efficiency, not to social efficiency (in a Pareto sense).

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Chapter 8: Usefulness of Accounting Information to Investors and Creditors Q-15

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Why does the concept of market efficiency (with respect to information) have no necessary relation to the quality of accounting information? Why is this distinction important with respect to accounting policy making?

Market efficiency refers only to the speed with which new information is incorporated into security prices. It says nothing about the quality of the underlying information. Although, in the extreme case, if the information were purely noise, one would not expect to see any evidence of information content, assuming that investors are sufficiently sophisticated. Q-16 Why is the efficient-markets hypothesis being challenged?

Numerous market anomalies have been reported. The Ou and Penman study, among others, raises the question of whether all publicly available information is really impounded in security prices. Also, post-earnings-announcement drift raises the question of why it takes up to 60 days for earnings announcements to be impounded in security prices. This may be due to transaction costs being too high for investors to take advantage of new information or possibly to underreaction to new information by security analysts. Q-17 What is meant by information content, and how does capital market research determine the information content of accounting numbers?

Information content is a term referring to abnormal security returns in response to the release of new, publicly available information. The research method is described in the chapter. There are two distinct problems with this research. The first relates to the implicit dual testing for both market efficiency (the efficient-market hypothesis) and information content (given an assumption of market efficiency). The second relates to the difficulties in applying asset pricing models, or even knowing if the asset model used is correct. Q-18 What is the advantage of being well diversified? Is there a downside? Why or why not?

There are two types of risk. The risk associated with an individual firm or entity is called unsystematic (diversifiable, unique) risk. This risk can be eliminated with diversification. The remaining portfolio risk is called systematic (undiversifiable, market) risk. Systematic risk is also known as the relevant risk as this risk must be borne by the investor. Diversification does reduce the investor's risk. However the more securities or assets that are added to an investor's portfolio, the less the investor is able to meaningfully analyze each security. In the extreme case, a "fully diversified" investor may know or care very little about the securities he or she holds. Q-19 If investors are well diversified (e.g., own several hundred stocks), will they have a greater or lesser need for accounting information? What does this say about diversification?

As indicated above, an investor who holds many securities does not have the time or resources to meaningfully analyze them. In this case, the investor is not able to effectively use the accounting information that is available. Hence, in effect, excessive diversification can lead an investor to be ignorant of his or her individual investments.

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Chapter 8: Usefulness of Accounting Information to Investors and Creditors Q-20 What are some limitations of capital market research?

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The study of price movements and the pricing mechanism in any market is an imposing task. Determining cause and effect between information and security prices is especially difficult because new information is continuously arriving. Since the set of information affecting security prices is large, it is difficult to isolate the effects of one piece of information. Furthermore, we are examining only a relatively small group of investors, those at the margin who influence stock prices. This difficulty means that the tests are going to be somewhat crude rather than precise. Failure to find evidence of information content should be interpreted cautiously, for the methodology may is not always capable of detecting information content. For this reason, the stronger evidence from efficient-markets research exists when there is information content rather than where there is none. Another weakness of capital market research is that it is a joint test of both market efficiency and the model used to estimate the abnormal returns. The absence of price responses is usually interpreted to mean that the information tested has no information content. This interpretation is correct only if the market is efficient and if the model used is correct. Finally market-based research considers only the aggregate effect of individual investor decision making. That is, the role of accounting information vis--vis an individual investors decision making is implicitly modeled as a black box; an event, occurs and the effect of this event is then inferred from whether or not there was an aggregate (market) reaction. Q-21 What is an event study?

An event study is an empirical research method used in accounting and finance studies to detect the markets reaction to some event that should have an impact on the stock price. Q-22 What are abnormal returns (AR) and cumulative abnormal returns (CARs)? What do they have to do with research in accounting? What do they have to do with accounting standards?

An event study divides the period related to the event into three windows: an estimation window, the event window, and the post-event window. The normal relationship between a securitys returns and those of the market is estimated during the estimation window. This allows the researcher to estimate the parameters for the linear regression equation. After the parameters have been estimated, the regression equation is used to estimate the returns at the time of and subsequent to the event. The difference between the actual return and the return expected using the regression equation is called an abnormal return (AR). The sum of the ARs is known as the cumulative abnormal returns (CAR). In the absence of an event, the ARs should randomly fluctuate around zero and the CARs should show no upward or downward trend. If an unexpected event has occurred, the AR and the CAR should depart significantly from zero on the date of the event. However, if the market fully and immediately reflects the new information in the stock price, the subsequent ARs should again randomly fluctuate around zero, and the CARs should show no trend.

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Event studies are a tool to allow researchers to examine the relationship between the security prices and the information contained in the firms financial statements and associated documentation. This body of research is important to standard setters. The ability of markets to efficiently allocate resources (allocational efficiency) is crucially dependant on accounting information for analysis, valuation, and performance measurement. Investors need to know if the analysis of accounting data is a value-enhancing activity. Furthermore, standard setters need to know if the existing standards are fulfilling their intended purpose to improve the informational and allocational efficiency of markets. If not, it might be time for a new standard. Q-23 Explain Lees (2001) view of market efficiency.

The null hypothesis for much of the capital markets research in accounting has been that the market fully and instantaneously adjusts to new information; the market price is equal to the securitys intrinsic value. This instantaneous response of the market is an extreme view. Lee offers an intriguing alternative in which the price convergence toward intrinsic value value is characterized as a process, which requires time and effort, and is only achieved at substantial cost to society. Q-24 Lee (2001) rejects the naive view of market efficiency. Explain. If Lee is correct, what are the implications for capital markets research in accounting?

Lee suggests that we have been asking the wrong questions. Instead of focusing on or assuming that the market responds instantaneously to new information, he suggests that we consider fundamental value and market prices as two distinct measures. Furthermore, instead of assuming or testing market efficiency, researchers should be studying why, when, and how prices converge to intrinsic value, and how current market prices might be improved. Q-25 For event studies, the post-event window is typically short (days or months). What are some issues associated with examining longer event windows (e.g., years)?

For all practical purposes, event tests assume that aside from the event tested, all other things remain the same (ceteris paribus). However, the longer the post-event window, the lower the likelihood that ceteris paribus does not hold. If it does not, it becomes more difficult to draw meaningful conclusions from the data. Q-26 What do we mean when we say that capital market research involves a joint test of both market efficiency and the model used to estimate abnormal returns?

In order to test the markets response to new information, the researcher must have a model of expected security returns. If the market does not appear to be efficient with respect to a piece of information, several possibilities may exist. The market might not be efficient with respect to the information analyzed. However, it is also possible that the model used to generate the expected returns might be flawed, providing for a flawed test. Unfortunately, it is impossible to separate the two.

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Chapter 8: Usefulness of Accounting Information to Investors and Creditors Q-27

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Describe the general findings from capital market research concerning the information content of accounting numbers and the effects of alternative accounting policies.

Accounting income numbers have evidenced information content in a wide variety of tests. It must be emphasized, though, that stock prices are probably affected as much or more by nonaccounting data. The research on alternative policies is ambiguous. Recent studies have used agency theory arguments to evaluate differences that, on the surface, appear to have noncash implications (see the discussion of Accounting for Exploration Expenditures in the Chapter 19 Oil and Gas Supplement). However, indirect consequences on owner wealth are offered to explain the stock price responses. Q-28 Why is the choice between the FIFOLIFO inventory methods an interesting issue in capital market research?

The early capital market studies were motivated by tests of whether or not investors were fooled by bookkeeping differences that had no direct cash flow effects on firms. This is an important issue with respect to how sophisticated we assume users areit will also affect the style and substance of accounting reports. For example, the FASB presumes that users are sophisticated. For the most part, the research rejects the naive investor hypothesis, though there are troubling anomalies such as the FIFO-LIFO research, which tends to support the notion that investors react naively to reported earnings without considering how those numbers have been constructed in terms of alternative (arbitrary) accounting policies. Q-29 As an investor, how would you react to a company changing its inventory accounting from FIFO to LIFO? Why?

It would depend on the level of analysis. Change inventory accounting from FIFO to LIFO would ordinarily result in higher cost of goods sold and lower accounting income. However, because the same inventory accounting method must be used for both financial reporting and income tax purposes, taxable income will be lower as well. If the firm pays income taxes, the firm's income tax bill should decline, and after-tax cash flow should rise. This would be good for shareholders. Q-30 Over the years, the research findings regarding changing from FIFO to LIFO have varied. Why do you suppose this is the case?

This issue, along with oil and gas accounting (see the discussion of Accounting for Exploration Expenditures in the Chapter 19 Oil and Gas Supplement), continues to produce some of the most anomalous results in capital market research. As with the oil and gas issue, the technical aspects of the research designs have varied across studies, as have the results. The research in this area highlights the problem of using capital market studies to study subtle issues of accounting policy choice (as opposed to more general questions such as the information content of reported earnings). Q-31 Why may accounting policies with no direct cash flow consequences indirectly affect investors or creditors?

The argument derives from the agency or contracting theory. Existing contracts can be affected by changes in accounting methods that affect accounting numbers used in the contracts. Typical

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uses of accounting numbers for contracting are in the areas dealing with restricting dividends, restricting new debt issues, and providing incentive compensation contracts with managers. Q-32 Why is it argued that capital market research cannot determine the optimality of accounting policies even for the limited investorcreditor group?

Because of externalities associated with financial reporting (free-riders), a market mechanism does not operate to determine the optimal production of information. Q-33 How do market-level and individual decision-maker analyses complement one another in studying the usefulness of accounting information to investors and creditors?

Market-level studies (i.e., capital market research) treat the individual decision maker as a black box, whereas the decision-maker studies focus explicitly on how decision makers respond to specific information cues in simulated laboratory decision making. Q-34 Lev talks about the low correlation between earnings and stock returns. Ou and Penman discuss the possibility of making abnormal returns based on published financial data. Are these papers in conflict with each other or complementary to each other? Why?

The papers complement each other. Since Ou and Penman see a predictive role for accounting in a market that may not be efficient, then Levs call for improved accounting measures certainly makes sense. Furthermore, even if the market were highly efficient, Levs call for improved accounting standards can be interpreted as being concerned with the quality of the signal picked up by the market, which should result in the market providing a more meaningful equating of risk and return for individual securities. Wyatt (1983) essentially makes this point. Q-35 What is post-earnings-announcement drift?

If markets are efficient, security prices respond instantly and fully to new, relevant information. Post-earnings-announcement drift refers to situations in which it takes a much longer period of time for the market to adjust to unexpected earnings announcements. In some cases, it takes up to 60 days for the full effect of unexpected earnings announcements to be impounded in security prices. Q-36 Why does post-earnings-announcement drift challenge the efficient-markets hypothesis?

Post-earnings-announcement drift is a contradiction of the efficient-markets hypothesis. The problem lies with the slow length of time it takes for new information to be impounded in security prices. Q-37 Why does post-earnings-announcement drift appear to be more pronounced with smaller firms? What could be done from a company perspective to rectify this situation? What could be done from a standard setting perspective to mitigate the effects of post-earningsannouncement?

Post-earnings-announcement drift appears to be more pronounced for smaller firms. There is evidence that financial analysts underreact to very fundamental signals stemming from securities, which in turn, lead to forecast errors and incomplete security price adjustments. There is also evidence that shareholders do not distinguish well between cash flow portions of earnings and 7th edition Page 10 of 16

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the accrual segment thereof. Another possibility is that in some cases, transaction costs are too high relative to the potential gain that can be earned from the mispricing of the securities. Finally, post-earnings-announcement drift appears to be inversely related to the number of experience analysts following the stock. With smaller firms, there are fewer analysts following the stock. Indeed, some small firms have no analysts following them. Smaller firms might be able to mitigate the problem by providing more disclosure and discussion of cash flows and other analyses normally provided by analysts. Accounting standards that improve the quality of financial reporting might eliminate some or all of the post-earnings-announcement drift, providing for better valuation of securities and ultimately, better allocation of resources in the economy. Q-38 What is the incomplete revelation hypothesis?

The incomplete revelation hypothesis is a hypothesis that may help to show why markets are less efficient than we have previously believed. One reason is that it may be more difficult to determine the effect of some numbers, particularly if they are buried in footnotes. Hence, stock option disclosures in the footnotes (SFAS No. 123) may be more difficult to assess than if they were in the body of the income statement. Also, the presence of noise traders may impact upon market efficiency. These individuals have their own purposes which may not bear directly upon assessing risk and return. For example they may simply be rebalancing their portfolios, attempting to attain more liquidity or simply be acting upon whims or irrational tips. Q-39 Suppose an accounting event occurs and there is no market reaction. What should we conclude?

It is sometimes hard to say. It could be that information was made available earlier via nonaccounting means. An example might be industry information revealed by a competitor. It is also possible that another piece of news has the exact opposite effect as the accounting event. For example, a firm may have a very positive earnings announcement on the same day that the Federal Reserve announces that it will increase interest rates. Q-40 Give some examples in which accounting information is not the most timely source of information affecting security prices.

There are many examples. In this space we offer only a few. A competitor might announce that the industry is in a slump. This is apt to affect all firms in the industry. A supplier might announce that its employees are on strike. This could jeopardize future inputs to a firm. Commodity prices might increase or decrease for a variety of reasons, and have an immediate affect on transportation companies. Q-41 Instead of employing capital markets research techniques (e.g., event studies) why dont we just ask investors how they would react to a hypothetical event? Why dont we ask managers why they make specific accounting changes?

This is an age-old question. Will the investors and managers provide a truthful answer? If they provide a truthful answer, will they provide an objective answer? Will their hypothetical answer

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be the same as their actual reaction? Finally, it is difficult to survey enough investors and managers in a timely fashion. In financial markets, we see the effects of decisions in real time. Q-42 Why is it important to improve the quality of accounting standards?

Accounting information is useful in making valuation and compensation decisions. These decisions affect securities pricing and ultimately, the efficient allocation of capital in the economy (allocational efficiency). Directly or indirectly, everyone has a vested interest in the correct understanding of the financial wellbeing of firms. Since accounting standards have a substantial affect on the type and quality of accounting information provided, we would argue that accounting standards have an affect on the efficient allocation of capital in the economy. With better standards, we would expect improved allocational efficiency. Q-43 What do pensions have to do with a companys operating performance? What do pensions have to do with the firms financing and investment decisions?

Operating performance and the ability to generate cash eventually affects the firm's financing and investment decisions. Poor operating performance might lead to increased financing needs or to a reduction in investment expenditures. The converse is true for good operating performance. It is possible that poor operating performance and sub-optimal investment decisions leads to pension underfunding. On the other hand, it is also possible that poor management of the pension fund in the form of severe underfunding or poor investment decisions, eventually leads to poor operating performance and sub-optimal investment decisions. It appears that investors frequently do not fully recognize that the severe underfunding has negative valuation effects. Why this happens is yet to be resolved. Even when investors recognize the severe underfunding, it is possible that they may not adequately factor in the implications of that underfunding, such as difficulty in refinancing at favorable terms or or the inability to refinance at all. Q-44 There is evidence that investors do not fully recognize the valuation effects of severe pension underfunding. (See, for example, Franzoni and Marn [2006]). Why do you suppose this is the case? What changes could be made to mitigate this problem?

Franzoni and Marn present evidence that the market significantly overvalues firms with severely underfunded defined benefit pension plans. Furthermore, the effects of the overvaluation persists for a long time. Perhaps investors do not analyze the information contained in the footnotes as it relates to pension funding. It is also possible that even when they examine the footnotes, some investors might not understand the information provided. Finally, it is necessary for investors to recognize the implications from the information provided. For example, a pension liability is a debta promise to paysimilar to a bond. Firms that have severe underfunding might find it difficult to refinance existing debt at favorable terms. Worse yet, it is possible that such firms may not be able to refinance existing debt at all. These kinds of constraints may affect a firm's ability to undertake future investments and eventually have a negative affect on future operating performance.

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It is possible that improved disclosure or better accounting standards might help investors to understand the significance a firm's underfunded pension. Including both pension assets and pension liabilities on the balance sheet might also be useful. Q-45 Why are accounting ratios valuable for predicting bankruptcy? What cautions do we need in evaluating accounting ratios?

Accounting-based ratios have been very useful in discriminating between firms that subsequently went bankrupt and those that did not. Prior to bankruptcy, companies that eventually go bankrupt tend to have financial ratios that differ from companies that do not go bankrupt. Predictability up to five years prior to bankruptcy has been demonstrated. Firms are complex enterprises, and it is not easy to reverse a positive or negative trend Note, however, that we must be very careful in drawing conclusions. Companies with poor ratios will not necessarily go bankrupt in the future. However, unless a company's operating or financial performance changes, bankruptcy is more probable for companies with poor financial ratios. Q-46 Accounting earnings are useful in predicting one-year-ahead cash flows. Is this sufficient? Why or why not?

From a financial economic perspective, the value of a firm is equal to the present value all expected future cash flows. Clearly, the value of the firm depends on much more than the oneyear-ahead cash flow. Nevertheless, the one-year-ahead cash flow might be indicative of subsequent cash flows. Q-47 Why do high levels of accruals appear to be mispriced?

Richardson, Sloan, Soliman, and Tuna find empirical evidence that suggests that accruals are related to earnings persistence. In addition, the less reliable the accruals, the lower the earnings persistence. Furthermore, they find that the market does not fully price the less reliable accruals. Future stock returns appear to be negatively related to accruals, and the negative relation is stronger for less reliable accruals. Liu and Qi provide evidence that the potential mispricing of accruals is substantial. There are a number of possible reasons for the mispricing. Nave investors may not look beyond the earnings numbers developed by accrual accounting. These unsophisticated investors may not distinguish between earnings and free cash flow. Chan, Chan, Jegadeesh, and Lakonishok suggest that the mispricing is due largely to managers manipulation of earnings, which is not recognized by some investors. Large increase in accruals may forecast a turning point in a company's prospects. If this is the case, earnings may continue to grow rapidly, but free cash flows may begin to decline. See Chapter 13 for a discussion of free cash flows.

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CASES, PROBLEMS, AND WRITING ASSIGNMENTS

1. The usefulness of accounting data to investors and creditors for predictive purposes is necessarily forward looking. However, under generally accepted accounting principles, financial statements are constructed primarily as an historical record. a. What limitation does this impose on the usefulness of financial statements for predictive purposes, and how is this limitation evident from the research reviewed in the chapter? b. Provide examples of important forward-looking events that either are not reported in financial statements or are not reported in a timely manner. c. Why may the feedback value of audited financial statements make them very important to investors and creditors even though predictive value is not necessarily high? The FASB conceives of accounting as an information system with the emphasis mainly on prospective cash flows. Since accounting systems are, by construction, historical records, they are necessarily backward looking. Therefore, feedback value is going to be better achieved than predictive value. Consistent with this is the low explanatory power of some capital market research. Unexpected earnings explain only about 5 percent or less of a firms abnormal stock return around the time of earnings announcements. The capital market literature presumes that accounting functions as an information system, but it is more likely that its main role is for contracting and hence feedback purposes. A good example is the mutually unperformed (executory) contract in which the firm and an outside party have an unperformed contract. By convention, such contracts do not meet the criteria for recognition. If accounting is primarily a feedback system, it is nevertheless useful precisely for this reason. From a contracting perspective, accounting is important in bringing about control and accountability to investors and creditors, and it is for this reason that accounting numbers are used in writing contracts. For example, debt contracts with restrictive covenants, and employment contracts with managers, especially incentive compensation agreements, also feedback and accountability. They are also helpful to users in predicting cash flows.

1.a.

1.b.

1.c

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Chapter 8: Usefulness of Accounting Information to Investors and Creditors 2.

Instructors Manual

A retail company begins operations late in 2000 by purchasing $600,000 of merchandise. There are no sales in 2000. During 2001 additional merchandise of $3,000,000 is purchased. Operating expenses (excluding management bonuses) are $400,000, and sales are $6,000,000. The management compensation agreement provides for incentive bonuses totaling 1 percent of after-tax income (before the bonuses). Taxes are 25 percent, and accounting and taxable income will be the same. The company is undecided about the selection of the LIFO or FIFO inventory methods. For the year ended 2001, ending inventory would be $700,000 and $1,000,000, respectively, under LIFO and FIFO. a. How are accounting numbers used to monitor this agency contract between owners and managers? b. Evaluate management incentives to choose FIFO versus FIFO? c. Assuming an efficient capital market, what effect should the alternative policies have on security prices and shareholder wealth? d. Why is the management compensation agreement potentially counterproductive as an agency-monitoring mechanism? e. Devise an alternative bonus system to avoid the problem in the existing plan. The bonus is part of the compensation agreement and is limited to financial performance. See computations below. FIFO LIFO Sales $6,000,000 $6,000,000 Cost of Sales 2,600,000 2,900,000 Gross Margin 3,400,000 3,100,000 Operating Expenses 400,000 400,000 Operating income 3,000,000 2,700,000 Taxes on operating income (25%) 750,000 675,000 Basis for Bonus 2,250,000 2,025,000 Bonus (1%) $ 22,500 $ 20,250 In terms of the bonus alone, management would choose FIFO over LIFO. However, after-tax cash flows will be higher under LIFO. FIFO LIFO Gross Margin $3,400,000.00 $3,100,000.00 Operating Expenses 400,000.00 400,000.00 Bonus (1%) 22,500.00 20,250.00 Pre-tax Income 2,977,500.00 2,679,750.00 Taxes (25%) 744,375.00 669,937.50

2.a. 2.b.

Difference in taxes paid is $74,437.50 in favor of LIFO ($744,375 minus $669,937.50).

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Chapter 8: Usefulness of Accounting Information to Investors and Creditors 2.c. 2.d.

Instructors Manual

LIFO should increase firm value due to higher positive cash flows arising from lower taxes, compared with FIFO. The agreement is a poor one because the bonus encourages a personal gain of $2,250 to the managers for choosing FIFO at a cost of $74,437.50 in higher taxes to the firm. This choice reduces shareholder wealth. Some alternative arrangement might include non-allocation bases such as sales or cash flow operations, or net cash flows (see chapter 13), or nonaccounting-based incentives such as stock option plans. Another alternative might be a bonus plan based on LIFO, with managements bonus percentage being slightly higher than it presently is to allow for the lower income under LIFO.

2.e.

CRITICAL THINKING AND ANALYSIS

1. How do you think the efficient-markets hypothesis should impact upon the drafting of accounting standards? Bear in mind that many questions have been raised about the efficient-markets hypothesis itself.

Accounting information is usually rapidly impounded into security prices. However, the FASB should notand has notbeen seduced by the EMH. First, the quality of accounting information can be improved (see Lev, 1989 and Wyatt, 1983). Second, the FASB should not be indifferent between providing information within the body of the financial statements themselves and disclosure in footnotes and supplementary information. Third, the FASB should try to increase publicly available information and reduce inside information. Finally, in the spirit of Lee, we need to design standards that work to improve market efficiency and eliminate obstacles that prevent market prices from converging rapidly to intrinsic value.

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