Final Paper – Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla,

Final Paper – Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla,
Final Paper Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla, Inc. The paper should include the theories or concepts discussed in the course. For example, you may relate theories discussed in class which either confirm or contradict or expand upon the material you find in the public domain. Another example, you may relate the financial statements and MD&A to theories which either confirm or contradict or expand upon the material you learned in the class. The total length for the paper should not exceed 4 pages double- spaced, minimum 11-point font. Grading will be based on the following criteria: Identification of relevant theories (Note 2) Understanding of theory Appropriate application of theory to the company (Note 2) Conclusions Use of relevant theories from throughout the course (See Note 1 below for details) Note 1 – there is not set amount of theories that you need to include in your paper; however, you are required at a minimum to apply at least one theory from the material covered pre midterm (Chapters 1 – 5), and at least one theory from the material covered post midterm (Chapters 6 – 11). You may also apply theories from Chapter 12 and 13; however, we will not cover these chapters in our lectures. Note 2 – Chapter 1 to 5 and 6 to 11 slides will be provided! Entity selected is Tesla, Inc.: Materials to use: you may use any information on the entity that is in the public domain, your textbook, your notes from class. Hint: check out the company’s Investor Relations section of the company’s website Tesla Investor Relations. I suggest that you refer to the most recent annual report, which is included in their 2022 Q4 10-K filing. Following is the link to investors relations: https://ir.tesla.com/#quarterly-disclosure to 2022 Q4 10-K filing. Note 3 – Provide references for all cited works including the textbook in a referencing format of your preference (citations do not count towards page limit). This is an example below on an assumption-based company: Example or Sample excerpt of final paper (Note this is only a portion of a paper and is a hypothetical company so no references have been added to this, your paper should include references to the sources of information and ensure that you have met the requirements as noted above): ABC’s share value has been on the downward trend. A component of ERC that explains the declining share price is earnings quality. When looking at earnings quality, and more specifically earnings persistence, ABC has volatile income and it is on a negative trend. Another factor impacting earnings quality is that the reported income is different from investors’ expectations. For example, ABC’s CEO stated in an interview in July of 2020: “we expect to see profitability for the company within the six to 12 months”. This ‘good news’ information kept people investing in the company. However, when the 2020 financial statements were released with a significant loss (ie. ‘bad news’), investors lost confidence in ABC, they revised their estimates of the future state and there was a corresponding decline in share price of ABC. Despite the bad news story as discussed in the preceding paragraph, ABC has other characteristics that support a ‘good news’ story for investors and potential investors. ABC has explained in their annual report that their higher expenses and greater losses is due to growth initiatives and product development under their strategic plan to grow their business organically. The significant losses present ‘bad news’ to the market; however, it could also be a sign of ‘good news’ for future years as they are investing in future growth. Using the Valuation Approach to Financial Reporting many of these investment in future growth would be reported as assets on the balance sheet, not expenses that reduce income at the transaction date. The company discusses the impact of the product development during 2020 in their Management Discussion and Analysis and noted that there were non recurring research expenses of $5m related to development of a new product line that had been expensed in the year that is not expected to re-occur in 2021. Investors can use this information to revise their beliefs about the future state of ABC and make investment decisions based on their revised beliefs. THE END
Final Paper – Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla,
•Chapter 5 – Value Relevance of Accounting  Information  Chapter 4 – Efficient Securities  Markets Recap •Security prices correctly reflect publicly  available information  •Full disclosure of accounting policies is  required to allow users to compare firms and  interpret financial results  Chapter 5 – Value Relevance of  Accounting Information  •How can we determine if investors / users are  in fact acting rationally and markets are  efficient?  –Ball & Brown study performed in 1968 looked at  value relevance •Value relevance = accounting information has  “value relevance” when security prices  respond to the information released.  Chapter 5 – Value Relevance of  Accounting Information  •Usefulness of financial statement information  evaluated by magnitude of security price  response to that information •Information is useful if it changes users  probabilities of outcomes (expectation of  good financial results or poor financial results)  •Information leads to changed probabilities,  and therefore buy/sell decisions  •Security price and share return change  based  on buy/sell decisions Chapter 5 – Value Relevance of  Accounting Information  •Abnormal share return –To t a l share return = return due to market‐wide  factors ±abnormal return due to firm‐specific  factors •Abnormal share return can be attributed to financial  accounting information •If good news in financial statements leads to positive  abnormal share returns (and vice versa), conclude  financial statement information is useful. •To reach such a conclusion, need to separate market‐ wide and firm‐specific share return Ball & Brown Study •B&B methodology –For Each Sample Firm: •Estimate investors’ earnings expectations  (proxied by  last year ’s actual) •Classify each firm as GN (actual earnings > expected  earnings) or BN (vice versa) •Estimate abnormal sharereturn for month of release of  earnings (month 0), using procedure of Figure 5.2 Ball & Brown Findings Ball & Brown Conclusions •B&B conclusion –Stock market reacts to earnings information in  month zero, but begins to anticipate the GN or BN  in earnings 12 months prior –Consistent  with securities market efficiency and  underlying rational decision theory Earnings Response Coefficients  (ERC) •Does quality of earnings affect magnitude of  abnormal share return? –Conceptually, quality of earnings is measured by  the main diagonal probabilities of the information  system •Higher main diagonal probabilities implies higher   quality –In practice, earnings quality often measured by: •Earnings persistence ‐higher persistence higher  quality Recap ‐Single Person Decision  Theory Information System for Decision Theory Given future Current period financial  profitability is: statements will show: Good news   Bad news High .80 .20 Low .10 .90 •If these probabilities provide additional  information about future profitability,  users will  be able to update their expectations. ERC vs. Ball & Brown •Ball & Brown looked at the direction of the  reaction (good news vs. bad news) and  direction of the stock price (price increase or  decrease) •Earnings Response Coefficient (ERC) looks at  the magnitude of the change vs. amount of  new informaiton  Earnings Response Coefficient ‐ERC •Other factors impacting ERC –firm specific risk – measured by beta  –Capital structure: higher D/E lower ERC –Growth opportunities: higher opportunities,  higher ERC –Earnings quality / Earnings persistence – higher  earnings quality, higher ERC  –Consistency of analysts expectation – higher ERC  Implications of ERC Research •Improved understanding of market response  to accounting information suggests ways to  improve the decision usefulness of financial  statements.  –Eg. there is evidence that there is a positive  relationship between ERC and earnings quality,  suggests that earnings quality is valued by equity  investors –Eg. ERC is lower for highly leveraged firms  suggests that full disclosure of liabilities (on and  off balance sheet) is required  Implications of ERC Research •Importance of earnings persistence to ERC  means that disclosure of the components of  net income is useful for investors  –detail, disclosure, supplemental information  –consider “extraordinary items”  •Recap Ball & Brown •Chapter 5 Ball & Brown Study •B&B methodology –For Each Sample Firm: •Estimate investors’ earnings expectations  (proxied by  last year ’s actual) •Classify each firm as GN (actual earnings > expected  earnings) or BN (vice versa) •Estimate abnormal sharereturn for month of release of  earnings (month 0), using procedure of Figure 5.2 Ball & Brown Findings Ball & Brown Conclusions •B&B conclusion –Stock market reacts to earnings information in  month zero, but begins to anticipate the GN or BN  in earnings 12 months prior –Consistent  with securities market efficiency and  underlying rational decision theory ERC vs. Ball & Brown •Ball & Brown looked at the direction of the  reaction (good news vs. bad news) and  direction of the stock price (price increase or  decrease) •ERC looks at the magnitude of the change vs.  amount of new informaiton  Group Discussion #1 •Explain what is meant by the value relevance  of accounting information.  Does it rely on the  historical cost basis of accounting?  Group Discussion #2 •IAS recognizes the need for full disclosure of  the components of reported net income.   Explain why full disclosure of net income  components is important if investors are to  properly interpret the implications of current  reported net income for future firm  performance.   Group Discussion #3 •What is classification shifting? Why does  classification shifting make it more difficult for  investors to predict future firm performance  from current reported net income? How could  the problem of classification shifting be  reduced?  Ball & Brown Question •PA R T A: The findings of Ball and Brown (1968), as  depicted in the following graph, provide various  insights.  What on their graph supported their  main finding that the market reacts efficiently to  earnings announcements?  •PA R T B: Describe what on their graph suggests  that the market is INEFFICIENT? Why?  •PA R T  C: If a well‐conducted study finds that  information released to the market is valuable, is  society better off if standard setters require that  firms produce that information?  Why or why  not? 
Final Paper – Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla,
Recap –Chapter 1 Chapter 2 Accounting Under Ideal Conditions Accounting under ideal conditions •In a perfect world, accounting information would: –be relevant; –be a faithful representation of “reality”  –be understandable;  –be verifiable; –be timely; and –facilitate comparisons. Under what conditions would this be achieved? Accounting under ideal conditions •Assume you have a situation where: –the future cash flows of the firm are publicly known with  certainty (=$150 at end of year 1, $150 at end of year 2) –the interest rate for the firm’s cash flows is publicly  known with certainty=10% •Present value of the asset = $______  •=($__/___) + ($___/___) = $____+ $____=  $____ •Who would be willing to pay more for this asset? •Who would be willing to sell this asset for less? Accounting under ideal conditions Balance Sheet of P. V. Ltd at time 0: Capital asset $ ______ Shareholders’ Equity  $_____ Accounting under ideal conditions For period 1, the income statement shows: Revenue $ Amortization Expense _____ Net income (_____*__%)                  _____ The amortization expense represents the decline in  the asset’s service‐rendering potential: Service rendering potential, time 0: $ Service rendering potential, time 1: ______ Decline ______ Accounting under ideal conditions Balance Sheet of P. V. Ltd at time 1: Cash $ Capital asset   S/H equity, t o $ Less amort.    ______ + net income    ______ $    ______ $    ______ •If there were only one share, it would be worth  $_______ Accounting under ideal conditions •For period 2, the income statement shows: Revenue $ Interest income Amortization Expense ______ Net income ______ The amortization expense represents the decline in the  asset’s service‐rendering potential: Service rendering potential, time 1: $  Service rendering potential, time 2: ______ Decline ______ Accounting under ideal conditions •Balance Sheet of P. V. Ltd at time 2: Cash $  Capital asset S/H equity, t1  $  Less amort. ______ + net income _____ $ _____ $ _____ •Is this information inclusive of the desirable  characteristics of relevance, representational  faithfulness (reliability), understandability,  verifiability, timely, and comparable?  Accounting under ideal conditions •Why is the firm’s net income in the previous  example not considered in the valuation of  the firm?  A bit of help on the terminology •Info is a “Faithful representation” of the real‐ world economic phenomena if the sub‐criteria  of neutrality, completeness and freedom from  error are met   “Confirmatory Value” is  the ability to confirm or  correct previous evaluations •Verifiability implies that different knowledgeable  and independent observers would reach general  consensus, although not necessarily complete  agreement, either:  a. That the information represents the economic  phenomena that it purports to represent without  material error or bias (by direct verification); or  b. That the chosen recognition or measurement method  has been applied without material error or bias (by  indirect verification).  •Neutrality is the absence of bias intended to attain  a predetermined result or to induce a particular  behavior  Ideal conditions with uncertainty: Q17 •We now consider a situation with the following conditions: –a given fixed interest rate (3%) for firm’s cash flows and  borrowings –a complete and publicly known set of states –asset yields publicly known state probabilities Probability annual cash flow .30 (no snow) $300 .70 (snow) $900 –publicly observable state realization –Equipment financed by bank loan of $500 and remainder by  issuing common shares  –Pays a dividend of $50 at end of each year of operation •What is the present value of North Ltd.’s asset on August 1,  2015 (time 0) and July 31, 2016 (end of year 1)?  Q17 cont. What is the present value of North Ltd.’s asset on August  1, 2015 (time 0) and July 31, 2016 (end of year 1)?  Q17 cont. •What items would appear on North Ltd.’s  balance sheet?  Q17 cont. •How do we calculate year one net income?  Q17 cont. For 2016,  with snowy (good) state realization, the income  statement shows: Revenue $ Amortization expense Interest expense _____ Net income $______              The amortization expense represents the decline in the  asset’s service‐rendering potential: Service rendering potential, time 0: $ Service rendering potential, end of 2010: _______ Decline $   _____ Q17 cont. Alternatively, for 2016, with snowy (good) state  realization, the income statement could show: Accretion of discount  ($______ x __) $ Interest accrued on bank loan ($____x__) Abnormal earnings (actual revenues of $900 less expected revenues of $720) _______ Net income $______ •Expected revenues (based on probabilities of  outcomes) of $_____  = (__x $___) + (__x $___) = $___+ $___= $___ Q17 cont. •What would the net income be under  historical cost accounting?  •Assumptions: –North Ltd. paid the present value of the  equipment at time 0 (calculated earlier)  –The equipment is amortized over 2 years on a  straight line basis Q17 cont. •Under the more realistic assumption that ideal  conditions do not hold, which measure of net  income, present value basis or historical cost  basis, is most relevant? Which is most  reliable? Why?  Don’t get lost in the mechanics: •Investment on B/S = PV of expected future cash  flows •Expected future cash flows = sum of (cash flow of  each realization * its probability) Traditional Format income statement: •Amortization = change in PV of asset •Cash on hand earns interest Alternative format income statement •Opening asset value*discount  rate=accretion=expected income •Difference between actual realizations and  expected = unexpected income Chapter 2 –Part 2  Present Va l u e Accounting in the  real world •The real world is not characterized by ideal  conditions; however, there are real world  examples of present value accounting. •Consider Reserve Recognition Accounting  (RRA) for oil and gas companies.   •RRA provide sufficient information to prepare  a present value based income statement.   Reserve Recognition Accounting •RRA requires supplemental disclosure of  present value, discounted at 10%, of a firm’s  proven oil and gas reserves.  –No IASB standard –NI 51‐101 (in Canada) requires supplemental  disclosure but not RRA  –ASC 932 (in the US) requires RRA disclosures  Reserve Recognition Accounting •ASC 932  –Requires companies to provide values of provenreserves  based on discounted expected future cash flows at a fixed  rate of 10%.  –Advantages: •Historic cost of these reserves may have little predictive value •Avoids problems of full cost vs. successful efforts –Intent: to provide investors with more relevant information  about future cash flows than that contained in  conventional historical cost‐based financial statements.  The mechanics of RRA •These things affect the  reserve “asset” and  total assets: –Change in prices, costs,  timing, estimates,  taxes, quantities –Extensions and  discoveries and  purchases of reserves  in place –Accretion of discount •These things are shifts  between the reserve  “asset” and other  assets: –Sales –Development costs  incurred Reserve Recognition Accounting •To address concerns of subjectivity and uncertainty,  companies: –Only look at proven reserves –Use a prescribed discount rate of 10% –Use prices and costs in effect at balance sheet date •Nevertheless, substantial estimations and revisions  are necessary regarding: –Quantities of reserves –Timing of cash flows –Revisions to prices and costs Reserve Recognition Accounting •Results in asset values and income that: –Fluctuate substantially –Are very different from historic cost counterparts •Mixed evidence whether RRA is informative or not  (covered in Chapter 5) Reserve Recognition Accounting •Do oil and gas firms operate under ideal  conditions? –What is the impact on present value accounting  under RRA requirements?   Reserve Recognition Accounting •Without ideal conditions, complete relevance  and reliability are no longer jointly attainable.  One must be traded off against the other.  Why do I have to learn this? •The mechanics of RRA are what accountants have to  do in general if we adopt asset valuations based on  present values (=revenue recognition at different  point).  Accounting for asset retirement obligations  works similarly to this, for example •Accounting also changes if we adopt asset valuations  based on market values  Current Va l u e vs. Historical Costs  •we have seen that ideal conditions do not  hold resulting in volatility and reliability issues  (consider RRA discussion)  •Will current value accounting (eg. present  value accounting) replace historical cost  accounting?  Current Va l u e vs. Historical Costs  •Relevance vs. Reliability  •Revenue Recognition •Recognition Lag •Matching of Costs and Revenues  Current Va l u e vs. Historical Costs  •Relevance vs. Reliability –Historical cost = reliable, not relevant –PV = relevant, not reliable (unless ideal conditions  hold) Current Va l u e vs. Historical Costs  •Revenue recognition  –revenue is recognized earlier under current value  accounting vs. historical cost accounting •Recognition Lag  –the extent to which timing of revenue recognition  lags behind changes in real economic value.  Current Va l u e vs. Historical Costs  •Matching of costs and revenues –matching is primarily associated with historical  cost accounting  –matching is accomplished by the use of accruals  (accounts receivable, accounts payable, allowance  for bad debts, amortization, etc.) –Little matching under current value accounting  •What is the impact of matching on reliability  of historical cost financial accounting? …think  estimates…  Current Va l u e vs. Historical Costs  •There are often several ways of accounting for  the same thing.  •Lack of well defined concept of net income  (should it be based on changes in current  values of assets and liabilities or on historical  costs and accruals?)  –Requires a great deal of judgement to value assets  and measure income … this is why we have an  accounting profession Current Va l u e vs. Historical Costs  •As there is value in both approaches to  financial accounting, the profession has  turned their efforts to making financial  statements more useful. •Chapter 3 –The Decision Usefulness Approach  to Financial Reporting  Recap –Ideal Conditions Recap –Ideal Conditions •Ch. 2. Q7 – Explain why, under ideal  conditions, there is no need to make  estimates when calculating expected present  values?  Recap –Ideal Conditions •Ch.2. Q10 – Explain why, under non‐ideal  conditions, it is necessary to trade off  between relevance and reliability when  estimating future cash flows. Define relevance  and reliability as part of your answer.  Chapter 2 – Part 3 Chapter 2 –Accounting Under  Ideal Conditions (Part 3)  •Last class we started our discussion on  accounting under ideal conditions, let’s  recap… Recap: Ideal conditions 1) What are the “ideal conditions”? Recap: Ideal conditions •Ideal conditions – conditions where future  firm cash flows and interest rates are known  with certainty or, if not known with certainty,  where there is a complete and publicly known  set of states of nature and associated  objective probabilities which enables a  completely relevant and reliable expected  present value of the  firm to be calculated.  Recap: Ideal conditions Ideal conditions under uncertainty: 1.a given, fixed interest rate which the firms  future cash flows are discounted 2.a complete and publicly known set of states of  nature 3.state probability objective and publicly known 4.state realization publicly observable  Recap: Ideal conditions ABC Co. Example •one asset firm, 2 year useful life, no salvage  value (ie. value of $0 at end of year 2) •no liabilities  •interest rate is 10%  •asset will generate $200 if the economy is  good, $100 if the economy is bad •50% chance the economy will be good,  and a  50% chance the economy will be bad. ABC Co. cont. •What is ABC Co’s asset value at time 0? •What does ABC Co’s balance sheet show at  time 0 (based on present values/current  values)? ABC Co. cont. What is ABC Co’s net income for year one  assuming a bad economy?  ABC Co. cont. What is ABC Co’s net income for year 1  assuming a good economy?  ABC Co. cont. •What would happen to the value of ABC Co. if  it paid a dividend?  ABC Co. cont. •Under ideal conditions, as long as an investor  can invest any dividends they receive at the  same rate of return as the firm earns on cash  flows not paid in dividends, the present value  of an investor’s overall interest in the firm is  independent of the timing of the dividends.   •This is true of ABC Co. because there  is only  one interest rate in the economy. ABC Co. cont. In effect, the firms cash flows establish the size of the  “pot” that is ultimately available to investors, and it  does not matter if this pot is distributed sooner or later.   If it is distributed during the year, investors can earn  10% on the distributions.  If it is distributed in a   subsequent year, the firm earns 10% on amounts not  distributed, but this accrues to the investors through  the increase in the value of their investment.  The  present value to the investor is the same either way.  …this is referred to as “dividend irrelevancy”  ABC Co. cont. Summary of ABC Co. financial statements: •Relevant: balance sheet values are based on  expected future cash flows •Dividend irrelevancy: fixed known interest rate  in economy  •Reliable: ideal conditions ensure that present  value calculations faithfully represent the  firm’s expected future cash flows •Management omission, error, and bias are not  p ossible.  ABC Co. cont. •Reliability vs. volatility –Present value calculations are reliable under ideal  conditions, net income and balance sheet value  are volatile since end of period present values  depend on which sate is realized.   –Volatility is demonstrated by abnormal earnings in  the ABC Co. example, where net income varied  from a loss of $23.97 to income of $76.03 under a  bad and good economy, respectively.  –The investor bears the risk even when the  financial statements are completely reliable.   Ideal Conditions ‐Terms  •dividend irrelevancy •risk averse •arbitrage  •abnormal earnings / unexpected earnings  Ideal conditions: class discussion 1) Do ideal conditions hold in real life? 2) What implications do these departures have  for accountants and financial statement  users? As we depart from ideal conditions: Implications ‐users need financial statements to assess what cash  flows are and what rate of return to expect/demand ‐the income statement gains importance  ‐quoted market price does not exist for all assets and  liabilities  ‐estimates are required in financial statements ‐impossible to anticipate all eventualities so “shocks”  occur more frequently Implications (cont.): ‐impossible to write contracts that cover all eventualities ‐financial statements provide feedback value as to the  state that occurred ‐difficult to disentangle results due to management  efforts/talent from nature ‐need auditors and GAAP to minimize chance that  management will try to cover up their mistakes, blame  them on nature Present Va l u e Accounting in the  real world •The real world is not characterized by ideal  conditions; however, there are real world  examples of present value accounting. •Consider Reserve Recognition Accounting  (RRA) for oil and gas companies.   •RRA provide sufficient information to prepare  a present value based income statement.  
Final Paper – Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla,
Part 1 – Chapter 3 – Decision Usefulness Accounting in non-ideal conditions • Chapter 2 covered accounting under ideal conditions • As we move into non-ideal conditions: – it is difficult (often impossible) for accounting to be both reliable and relevant at the same time. – valuation based on future cash flows (eg. reserve recognition accounting) are problematic, largely due to concerns regarding reliability (= faithful representation) – income becomes an important concept, but it is difficult to measure Some Problems with income measurement • Income based on change in PV and MV would be unreliable • Income based on change in HC presents problems: – Leaves out elements that would be captured by MV or PV based income (human resource training, advertising, changes in value of assets, internally developed goodwill) – Income is affected by accounting choices, such as amortization, inventory costing, revenue recognition – When costs are incurred, must determine whether they are assets or expenses How to evaluate accounting? • Accounting is beneficial if it is useful in making decisions. In particular we concentrate on the investment (resource allocation) decision. • Decision usefulness = the ability of financial accounting information to help users make good decisions. • How do we determine whether information is useful or not? – theoretical models of decision making – empirical evidence Decision Usefulness • If decision usefulness is the ability of financial accounting information to help users make good decisions… what do we mean by “users”? Decision Usefulness • There are a diverse set of users to financial accounting information: Equity investors, debt investors, managers, unions, standard setters, and governments. What are the decision problems of these financial statement users? – …the answer is not an obvious process. For example, what information does an investor need to make a rational decision about whether to buy or sell certain shares or debt? Would this decision be helped or hindered by current value accounting? Conservative accounting? Decision usefulness • To answer these questions, we look to theories in finance and economics: The “theory of rational decision making” or the “decision theory” for short. • Accountants have decided that investors are a major constituency of users of financial accounting information and have turned to understand the type of financial statement information investors need. Single person decision theory • Accounting is useful when it provides information about future states of nature. • Financial statements can be useful to the extent that they enable a prediction that the good or bad news they contain will persist into the future. • Therefore, even historic cost based financial statements can be useful Single Person Decision Theory Information System for Decision Theory Given future Current period financial profitability is: statements will show: Good news Bad news High .80 .20 Low .10 .90 • If these probabilities provide additional information about future profitability, users will be able to update their expectations. Information systems • Financial statements (even those based on past information) have value. • The riskier a gamble is, the more “disutility” is incurred by a risk-averse investor, so investors need information about risk. • As risk increases the more information can increase utility (all other things being equal). Single Person decision theory: Wrap – up • To be useful, accounting needs to: – provide information about the extent to which future states are linked to current period financial results. They must provide more information than “noise” – provide information about risk. If a risk averse investor can decrease his risk, while preserving a given level of return, he will increase his utility. Increasing Decision Usefulness • Management Discussion and Analysis (MD&A) – A standard that requires firms to provide a narrative explanation of company operations to assist investors to interpret the firms financial statements. – Required for public companies – Managements comments on company performance, financial condition, risks, and future prospects. – Includes forward looking information – Non-GAAP measures Part 2 – Chapter 3 – Decision Usefulness Decision Usefulness • Under SPDT, people make decisions that maximize their utility • Utility is a function of wealth and risk (in Chapter 9, leisure is added in too). • Need information about cash flows and probabilities • Information that updates (changes) those cash flows or probabilities is useful Decision Usefulness • The information systems show the connection between the future states and what is reported in the financial statements • The diagonal elements show a “sensible” connection, while the off-diagonal elements are “noise” • The higher the diagonal elements, the more useful the system as there is a stronger connection Standard Setters Reaction • Framework objective: to provide information that is “useful to present and potential investors, lenders, and other creditors (“primary users”) about providing resources to the entity.” • “Primary users” need information about the amount, timing, and uncertainty of the firms future cash flows. • Assumes risk averse investors, risk neutral investors would not care about uncertainty. Standard Setters Reaction • Desirable characteristics of useful information: – Relevant – Reliable – Timely – Comparability – Verifiability – Understandability Chapter 3 – Summary • Accountants need to understand the decision problems of financial statement users • Single person decision theory tells us that users need information to help assess a securities expected return and the risk associated with the return • Financial statements are a cost effective (to the investor) source of information Chapter 3 – Summary • GAAP is an information system that helps investors predict future firm performance (and future investment returns) • Accountants need to find the most useful trade-off between relevance and reliability • Accountants also need to consider timeliness, comparability, verifiability, and understandability Chapter 3 – Summary • MD&A is a future oriented report on firm performance • MD&A focuses on relevance over reliability – non-GAAP measures are not comparable – not subject to audit
Final Paper – Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla,
•Chapter 6 –The Measurement Approach to  Decision Usefulness  Recap Chapter 5 –Value Relevance •accounting information has “value relevance”  when security prices respond to the  information released.  •Ball & Brown study –Stock market reacts to  earnings information but anticipates the  information  •ERC ‐Does qualityof earnings affect  magnitude of abnormal share return Ball & Brown Findings Chapter 6 – Measurement  Approach Is the market efficient? •Market efficiency relies on rational investors.   On an individual basis, lots of evidence that  people aren’t rational: –People take credit for their successes, blame  nature for failures.  So if stocks go up, people feel  they’re smart, buy more, causing momentum.   However, they don’t want to sell losers, resulting  in underreactions…. –Prospect Theory  Prospect Theory •People are loss‐averters, so they will hang on  to losers and sell winners •Individuals also tend to overweight salient,  anecdotal and extreme evidence  –Underestimate probabilities of likely states –Overestimate probabilities of unlikely states What Is the Measurement  Approach? •Greater use of current values in the financial  statements proper •Recall two versions of current value –Fair value: exit price –Va l u e‐in‐use: present value of future cash receipts  or payments •Goal of measurement approach is to increase  decision usefulness by increasing financial  statement relevance Why the Measurement Approach? •Decision Usefulness Perspective tells us  whether information released has an  influence on decisions (presumably because it  changed users’ assessment of firm value) BUT: •It does NOT tell us whether the original or revised  assessments of firm value are reasonable So, our next question is: •What is the relationship between accounting valuation  (particularly the balance sheet) and market valuation  and can we strengthen that relationship?  Why Are Accountants Moving  To w a r d s a Measurement  Approach? •To extent  average investor not fully rational  and securities markets not fully efficient, a  measurement perspective may improve  decision‐making and market efficiency –The greater relevance of current values may  enable ordinary investors to improve their  decision making –This assumes that the increased relevance is not  outweighed by lower reliability Why Are Accountants Moving  To w a r d s a Measurement  Approach? •Empirical evidence that net income explains  very little share price variation (i.e., net  income has a low “market share” in terms of  information that drives the market). Lev  (1989), Section 6.9 •Better measurement (eg. fair value  measurement?) may increase accounting  “market share” in explaining share price  changes. Why Are Accountants Moving  To w a r d s a Measurement  Approach? •Ohlsön’s clean surplus theory –A theoretical framework supportive of a  measurement approach •Auditor Liability –Better measurement may reduce auditor liability  when firms become financially distressed Measurement Approach •Accounting should help users value investment  alternatives –De we provide info about risk, future cash flows? Even if  we do, can investors calculate value themselves? •Standard setters currently face many challenges  related to valuation –Intangibles in new economy? Financial instruments? •Accountants are under increasing pressure to ensure  that financial statements are relevant to investors –More litigation –Higher public expectations –Many highly publicized business failures In Class Discussion •Chapter 6 Textbook Question 1 •Why does a measurement approach to  decision usefulness suggest more value  relevant information in the financial  statements proper, when efficient securities  market theory implies that financial statement  notes or other disclosure would be just as  useful?   Auditor Liability •Will a measurement approach reduce auditor  liability? –Perhaps •Auditor can claim that the financial statements proper  anticipated value changes, rather than buried in  supplemental information or not disclosed at all •But, current values may be subject to manager  bias if no market value available (incomplete  markets) •Then, may be hard for auditor to resist manager bias Auditor Liability and Conservative  Accounting Example –A change in asset value has already occurred –Assume investor is risk averse –Investor opportunity loss of expected utility if a  decline in asset value is not recorded = 1.02 –Investor opportunity loss if an increase in asset  value not recorded = .52 –Then, investor more likely to sue auditor  if a  decline in asset value not recorded. –Auditor reaction: impairment tests, to reduce  likelihood  a decline in asset value is unrecorded,  thereby reducing likelihood of lawsuit In Class Discussion  •Chapter 6 Textbook Question 4 •Explain in your own words what “post  announcement drift” is. Why is this an  anomaly for securities market efficiency? Give  two behavioral biases that could generate  post announcement drift.   Measurement Approach •Accounting should help users value investment  alternatives –De we provide info about risk, future cash flows? Even if  we do, can investors calculate value themselves? •Standard setters currently face many challenges  related to valuation –Intangibles in new economy? Financial instruments? •Accountants are under increasing pressure to ensure  that financial statements are relevant to investors –More litigation –Higher public expectations –Many highly publicized business failures Conclusions on Measurement  Approach •Assuming reasonable reliability, current value  accounting can increase decision usefulness relative  to historical cost accounting •Increased use of current value accounting (including  impairment tests) in financial reporting because:  •Markets not fully efficient •Low explanatory power of net income for share returns •Ohlsön clean surplus theory •Auditor liability •Decision usefulness for investors may be further  increased by conservative accounting   Chapter 6 –Question for  Discussion •The 2007 – 2008 meltdown of the market for  asset‐backed securities is often blamed on lax  mortgage lending practice, poor risk controls  by financial firms, greedy managers, and  inadequate regulation. However, the  meltdown also has important implications for  financial accounting and reporting practice.   Give two such implications and, for each  one,  explain why accountants should be aware of it  and take is seriously.  (Hint: see also Chapter 1  –Section 1.3) Copyright © 2015 Pearson Canada Inc. Chapter 7 7 – 1 Copyright © 2015 Pearson Canada Inc.7 – 2 Current Value Accounting •Value-in-use –Also called amortized cost –Valued at discounted present value of future receipts –Relevance: high –Reliability: •Error and possible bias in estimating •Management may opportunistically change intended use to increase present value or avoid impairment writedown >> Continued Copyright © 2015 Pearson Canada Inc. Current Value Accounting (continued) •Fair value –Definition under IFRS 13 •The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date –Also called exit price –Exit price measures opportunity cost of retaining asset/liability in firm •Hence a stewardship aspect in addition to valuation aspect. •If manager cannot earn at least cost of capital on asset, should be sold >> Continued 7 – 3 Copyright © 2015 Pearson Canada Inc. Current Value Accounting (continued) •Market price does not exist for many assets –Fair value hierarchy; IFRS 13, ASC 820-10 •Level 1: market price exists •Level 2: market price of similar asset exists •Level 3: no market price, fair value must be estimated –Effect on reliability as move from level 1 to levels 2 and 3? >> Continued 7 – 4 Copyright © 2015 Pearson Canada Inc.7 – 5 Examples of Current Value Accounting •Accounts receivable and payable –Approximates value-in-use if time is short •Lower-of-cost-or-market rule –E.g., inventories –Rule is example of conservativism, also a partial application of current value accounting >> Continued Copyright © 2015 Pearson Canada Inc. Examples of Current Value Accounting (continued) •Revaluation option for property, plant & equipment, IAS 16 –Option to value at fair value –Not available under FASB standards •Impairment tests –E.g., property, plant & equipment •Valued at recoverable amount if less than book value •An example of conservatism, also a partial application of current value accounting 7 – 6 Copyright © 2015 Pearson Canada Inc.7 – 7 Financial Instruments •Definition –A contract that creates a financial asset of one firm and a financial liability or equity instrument of another firm •Note broad definition of financial assets and liabilities •Includes both primary and derivative financial instruments Copyright © 2015 Pearson Canada Inc.7 – 8 Financial Instruments •IFRS 9 •Financial assets and liabilities recorded at fair value at acquisition •After acquisition, financial assets valued at fair value, with unrealized gains and losses generally included in OCI, •Unlessobjective of firm’s business model is to hold an asset to collect interest and principal. –Then, valuation is at amortized cost (i.e., value-in-use), subject to impairment test –Business model concept makes it more difficult for management to opportunistically change intended use of the asset •After acquisition, most liabilities valued at amortized cost Copyright © 2015 Pearson Canada Inc.7 – 9 The Fair Value Option for Financial Instruments •Under IFRS 9, firm may designate financial assets/liabilities at acquisition as valued at fair value to reduce a mismatch. –Applies to assets/liabilities otherwise valued at amortized cost –Mismatch: Accounting volatility greater than real volatility •E.g., loans receivable valued at fair value •Bonds payable hedge the loans, valued at amortized cost •Unrealized gains/losses on loans included in net income •No offsetting loss/gain recorded on bonds •If bonds fair valued, losses/gains on bonds offset gains/losses on loans >> Continued Copyright © 2015 Pearson Canada Inc.7 – 10 The Fair Value Option for Financial Instruments (continued) •Accounting for changes in own credit risk –Firm has opted under IFRS 9 to fair value debt outstanding –Firm’s debt receives a credit downgrade –Market value of debt falls –Firm writes debt down to fair value, records a gain –Has firm really gained? •Barth, Hodden, and Stubben (2008) –IFRS 9 requires own credit risk gains/losses to be included in OCI Copyright © 2015 Pearson Canada Inc. Loan Loss Provisioning •Applies to loans valued at amortized cost •During 2007-2008 securities market meltdowns, huge loan losses reported by financial institutions contributed to investor loss of confidence •2013 IASB exposure draft –Include estimate of future losses in expected loan collections –Loan losses thus recognized sooner than when actually impaired, reducing investor shock –Relevance v. reliability tradeoff? Decision useful? –Currently awaiting agreement with FASB on a converged standard 7 – 11 Copyright © 2015 Pearson Canada Inc. Fair Value v. Historical Cost •The 2007-2008 market meltdowns generated serious complaints about fair value accounting •Several analytical models study conditions under which each system is preferred –Allen & Carletti (2008) –Plantin, Sapra, & Shin (2008) –Models have restricted assumptions –Mixed empirical support 7 – 12 Copyright © 2015 Pearson Canada Inc. Derecognition and Consolidation •Purpose of new standards is to reduce abuses leading up to 2007/2008 market meltdowns –Derecognition •When can a firm remove assets from its books? –A serious question leading up to 2007-2008 market meltdowns –E.g., many firms transferred securitized mortgage assets to SIVs •IFRS 9. •Can derecognize when substantially all risks and rewards of ownership are transferred. •But no derecognition if control retained –Consolidation •IFRS 10 –Required when one entity controls another –Control exists when one firm has power over another and bears risk of return on its investment 7 – 13 Copyright © 2015 Pearson Canada Inc.7 – 14 Derivative Financial Instruments •Derivatives are financial instruments •Definition –A contract, the value of which depends on some underlying… –May not require an initial cash outlay –Generally settled in cash, not in kind •Derivatives valued at fair value under IFRS 9 •Unrealized gains and losses included in net income, except certain hedging contracts >> Continued Copyright © 2015 Pearson Canada Inc.7 – 15 Derivative Financial Instruments (Continued) •Hedge Accounting –Purpose of hedges is to manage risk •Price risks (e.g., commodity prices, interest and foreign exchange rates), credit risks (credit default swaps) –Fair value hedges •Gains and losses on the hedging instrument included in net income –Fair valuing the hedged item offsets effect on net income –Cash flow hedges •Gains and losses on the hedging instrument included in OCI, until the future transaction affects net income »Continued Copyright © 2015 Pearson Canada Inc.7 – 16 Derivative Financial Instruments (continued) •Benefits of Hedge Accounting –Reduces earnings volatility •Offset gains/losses by fair valuing hedged item (fair value hedge) •Delay gain/loss recognition by including in OCI until realized (cash flow hedge) »Continued Copyright © 2015 Pearson Canada Inc.7 – 17 Derivative Financial Instruments (Continued) •To Obtain Benefits of Hedge Accounting –Hedges must qualify •Must be highly effective –High negative correlation with hedged item –Hedges must be designated •To reduce temptation to speculate •Requires elaborate procedure and documentation Copyright © 2015 Pearson Canada Inc.7 – 18 Accounting for Intangibles •Many intangibles are not on balance sheet •Purchased intangibles, on balance sheet –Goodwill arising from an acquisition •Accounted for at cost •No amortization •Subject to impairmentg test –Can lead to major writedowns –Management devices to work around goodwill and related writedowns •“Pro-forma income,” e.g., TD Bank, 2000 Annual Report, JDS Uniphase Corp. See Theory in Practice 7.5 »Continued Copyright © 2015 Pearson Canada Inc.7 – 19 Accounting for Intangibles (continued) •Self-developed intangibles –Self-developed goodwill, e.g., from R&D •Hard to reliably determine fair value •Research costs written off as incurred, development costs capitalized, under IAS 38 •Development costs also written off under FASB standards •Recognition lag: instead of valuation on balance sheet, goodwill value from R&D shows up over time on income statement •Recognition lag responsible for low ability of net income to explain stock returns? –Lev & Zarowin (1999) argue yes >> Continued Copyright © 2015 Pearson Canada Inc.7 – 20 Accounting for Intangibles (continued) •Lev & Zarowin (1999), “The Boundaries of Financial Reporting…” –Their study documents a decreasing usefulness of earnings information –Usefulness evaluated by ability of earnings to explain abnormal share return •Low R 2 –And falling? •Low ERCs •Especially for research-intensive firms »Continued Copyright © 2015 Pearson Canada Inc.7 – 21 Accounting for Intangibles (continued) •Lev & Zarowin (continued) –Conclusion •Accounting for intangibles is inadequate •Their suggestion to improve usefulness –Capitalize successful intangibles after a “trigger point” is attained •Amortize over useful life •Like successful efforts accounting in oil and gas •Amounts capitalized and amortized may reveal inside information to investors, since it is management that has best knowledge of R&D value >> Continued Copyright © 2015 Pearson Canada Inc. Accounting for Intangibles (continued) •Capitalization of intangibles creates a problem of low reliability –Kanodia, Singh, & Spiro (2005) present a model suggesting that some degree of unreliability is “good” 7 – 22 Copyright © 2015 Pearson Canada Inc.7 – 23 Reporting on Risk •Risk controlled by natural hedging + hedging with derivatives •Some reasons for managing firm-specific risk, even though investors can diversify it away –Reduce investor estimation risk –Cash availability for planned capital expenditures –Control speculation by managers –Reduce likelihood of major losses, which often lead to lawsuits >> Continued Copyright © 2015 Pearson Canada Inc.7 – 24 Reporting on Risk (continued) •Reporting on Risk –Some reasons why reporting on other (firm-specific) risks also relevant to investors •Risk information may reduce estimation risk •Hedging may prevent losses, reducing auditor & firm legal liability •Risk reporting may control manager speculation >> Continued Copyright © 2015 Pearson Canada Inc.7 – 25 Reporting on Risk (continued) •A Measurement Perspective on Risk Reporting •Narrative, in MD&A –Canadian Tire Corp. 2012 Annual report •Text, Section 3.6 •Sensitivities Analysis –Husky Energy Inc., 2012 Annual Report •Table 7.2 •Value at Risk –Microsoft Corp., 2012 Annual Report Copyright © 2015 Pearson Canada Inc.7 – 26 Conclusions on Application of the Measurement Approach •Standard setters continue to favour current value measurements in financial statements –Conceptual framework emphasizes balance sheet approach –Some current value measurements are one-sided •Lower-of-cost-or-market, ceiling tests –Some backing off from fair value post 2007- 2008 market meltdowns •E.g., IFRS 9 business model concept allows increased use of amortized cost •Accountants are recognizing an increased obligation to measure and report on firm risk
Final Paper – Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla,
•Chapter 10 –Executive Compensation Recap ‐Agency Theory •Agency theory, a branch of game theory,  which studies the design of contracts between  principal and agent that motivate the agent to  work in the best interest of the principal. •An efficient contract will do this at the lowest  cost to the principal.   •In many cases the effort of the  agent is not  directly observable by the principal –this  creates a moral hazard problem –agent needs  to be sufficiently motivated to work hard.  Holmstrom •Properties of a good performance measure =  the best trade off between sensitivity and  precision •Properties of good information to investors =  best trade off between relevance and  reliability  Executive Compensation •Executive compensation plans follow agency  theory but are complex and generally span  multiple periods •Attempts to align the interest of the owners  and manager by basing the mangers  compensation on one or more measures of  the managers performance in operating the  firm •Many are based on two measures: net income  and share price Executive Compensation •Why are incentive contracts necessary?  –As discussed in Chapter 9, managers have the  option to work hard or not, contracts are needed  to align managers and owners interests, that the  manager will work hard for the owner •Fama (1980) study suggests that the simple  contracts as discussed in chapter 9 are not  necessary, that the managerial labour market  will control manager shirking – reputational  risk.  Executive Compensation •What was missing from Fama’s argument –managers have the ability to hide shirking in the  short run by controlling the release of information  (moral hazard)  •Conclusion: managerial labour forces control  manager tendencies to shirk, they do not  eliminate them  •Effort incentives based on some measure of  the payoff (ie. net income) are desirable for  efficient contracting  RBC Example •See Example 10.1  •RBC compensation structure considers  incentives, decision horizon, and risk  properties.  •Three main incentive components:  –short term inventive awards based on earnings  and individual achievement  –long term stock option whose value depends on  share price performance  –mid term awards whose value depends on both  Theory of Exec. Compensation •what determines the relative importance of  net income and share price in evaluating  managers performance?  –important consideration for accountants as  motivating manager performance is an important  social goal  •…the more sensitive net income is to manager  effort the greater the weighting to net income  in measuring manager performance  Theory of Exec. Compensation •How to make net income more sensitive to  manager effort:  –reduce recognition lag by moving to current value  accounting  –this increases sensitivity since more of the future  payoff from manager effort show up in current net  income  •However, current value accounting reduces  the precision of net income  Theory of Exec. Compensation •How to make net income more sensitive to  manager effort:  –full disclosure of low persistence items  –allows compensation committee to better  evaluate manager effort and ability and thus to  evaluate earnings persistence  Theory of Exec. Compensation •Consider sensitivity of share price –Holmstrom –it will always reveal addition payoff  information beyond that contained in net income  •Consider precision of share price –low due to economy wide factors that can impact  share price  •Therefore, we generally see a mix of net  income and share price measurement of  performance  Theory of Exec. Compensation •If we have a mixed model (using share price  and net income to measure manager  performance) we need to consider how the  mix of these measures impacts the decision  horizon of the manager –does it encourage short term or long term  thinking, or a balance?  Theory of Exec. Compensation – Risk  •Consider managers effort from a risk  perspective –in chapter 9 we learned that in the presence of  moral hazard, the manager must bear some  compensation risk if effort if to be motivated  •The higher the risk the manager bears, the  higher their expected compensation needs to  be  Theory of Exec. Compensation – Risk  •Need a balance of risk imposed on the  manager –too much and they will avoid  investing in some projects that could benefit  the firm, too little and they will not work hard •How to control compensation risk: –relative performance evaluation (RPE) –bogey (ie. minimum limits, not requiring payment  to the firm in the case of a loss)  –cap –a maximum  –conservative accounting – delaying recognition of  unrealized  g ains  Theory of Exec. Compensation – Risk  •Conservative accounting, however, also will  limit the managers incentive to invest in riskier  projects –this is why share price is included as  a measure as well, to encourage longer term  decision horizon  •ESO’s (Employee Stock Options) are a  commonly used tool –they can however have  negative impacts. eg. Enron and  Worldcom fraudulent financial reporting to support stock  price  Theory of Exec. Compensation – Risk  •Conclusion: –a mix of performance measures is desirable  –Compensation in the form of ESO’s and or  company shares encourages upside risk and a  longer run decision horizon while net income  based compensation (if differed and subject to  claw back) imposes some downside risk to  discourage excessive risk taking that pure share   based compensation may create  –Corporate governance ‐compensation committee  Politics of Exec. Comp. •significant public backlash after high executive  compensation payments made  •studies including Gayle & Miller (2009)  suggest that managers are not overpaid  relative to shareholder value created  •Compensation is to cover effort disutility  (recall from chapter 9 the disutility of having  to work hard) and compensation risk the  manager bears Power Theory •Until now we have focussed on efficient  contracting view of executive compensation –compensation committees are sophisticated in  their use of accounting information –managers may not be over compensated (when  considering disutility function) •We will now look at Power Theory  –executive compensation in practice is driven by  manager opportunism, not efficient contracting  Power Theory •managers have sufficient power to influence  their own compensation and they use this  power to generate excessive pay at the  expense of shareholder value  •The power theory questions the efficiency of  the managerial labour market  •How to control manager power  –Strong corporate governance  –public “outrage”  –possibility of takeover / dismissal  Power Theory •How can accountants help –assist in the governance process –full disclosure of low persistence items  –requirement to record an expense for ESO’s at  grant date  –disclosure of executive compensation  •other ways to control abuse of power –restrictions on the amount of executive  compensation that is tax deductible for a firm  –surtaxes on high bonuses (UK and France) Conclusions •Financial reporting  plays two important roles  in motivating manager effort –Provides an informative performance measure  input into compensation contracts •helps compensation committees tie pay to  performance, control manager power, and increase  contract efficiency –Improves working of managerial labour markets  •Full disclosure helps labour market evaluate manager  performance and establish reputation Conclusions •Role of financial reporting in motivating  manager performance and improving the  working of managerial labour markets equally  important to social welfare as improving  operation of capital markets •Chapter 11 –Earnings Management  In class discussion •Question 8 –Chapter 11 – General Electric  Company  Recap –Executive Compensation •Attempts to align the interest of the owners  an manager by basing the mangers  compensation on one or more measures of  the managers performance in operating the  firm •Many are based on two measures: net income  and share price Recap –Executive Compensation •Fama argued that contracts were not  necessary, that the managerial labour market  would control manager effort  •However, managers have the ability to hide  shirking in the short run by controlling the  release of information (moral hazard)  •Conclusion: managerial labour forces control  manager tendencies to shirk, they do not  eliminate  them  Recap –Executive Compensation •Compensation structures consider incentives,  decision horizon, and risk properties •Three main incentive components:  –short term inventive awards based on earnings  and individual achievement  –long term stock option whose value depends on  share price performance  –mid term awards whose value depends on both  Recap –Executive Compensation •Need a balance of risk imposed on the  manager –too much and they will avoid  investing in some projects that could benefit  the firm, too little and they will not work hard Recap –Executive Compensation •Compensation in the form of ESO’s and or company  shares encourages upside risk and a longer run  decision horizon while net income based  compensation (if differed and subject to claw back)  imposes some downside risk to discourage excessive  risk taking that pure share based compensation may  create  •High executive compensation  is to cover effort  disutility (recall from chapter 9 the disutility of  having to work hard) and compensation risk the  manager bears Recap –Executive Compensation •Power Theory ‐executive compensation in  practice is driven by manager opportunism,  not efficient contracting  Recap –Executive Compensation •Properties of a good performance measure =  the best trade off between sensitivity and  precision •Financial reporting  plays two important roles  in motivating manager effort –Provides an informative performance measure  input into compensation contracts • helps compensation committees tie pay to performance, control  manager power, and increase contract efficiency –Improves working of managerial labour markets  •Full disclosure helps labour market evaluate manager performance  and establish reputation Earnings Management • Earnings management is the choice by a manager of accounting policies (accruals), or real actions, that affect earnings so as to achieve some specific reported earnings objective – Real actions to manage earnings include, for example, cutting or increasing R&D and advertising; manufacturing for stock – Accrual-based earnings management includes, for example, managing the allowance for bad debts, changing amortization policy Earnings Management • Here, we concentrate primarily on the role of accruals in earnings management – Note the “iron law” of accruals reversal: if accruals increase earnings this period, their reversal lowers earnings in future periods • Two types of accruals – Non-discretionary: management has little discretion to control amounts – Discretionary: management has discretion to control amounts – To discover role of accruals in earnings management, accountant needs to separate these two types Earnings Management •Patterns of earnings management  –Bath –Income minimization –Income maximization –Income smooth Earnings Management •Motivation for earnings management: –A contractual motivation – •Managing earnings to maximize cash bonus  •To avoid violation of debt covenants  •To avoid political costs (tariff protection)  •To meet  investors’ earnings expectations (strong  negative share price reaction if expectations not met,  damage to manager reputation if expectations not met) •Initial public offerings (to increase proceeds of new  share  issues) The Good Side of Earnings  Management •Investor‐based arguments for good earnings  management:  –To credibly communicate inside information to  investors •Discretionary accrual management as a way to credibly  reveal management’s inside information about  earnings expectations The Good Side of Earnings  Management •Contract‐based arguments –To give firm some flexibility in the face of rigid,  incomplete contracts •Bonus contracts based on net income –New accounting standards may lower net income and/or  increase volatility, lowering manager’s expected utility of  compensation. May adversely affect manager effort •Debt covenant contracts –New accounting standards may increase probability of debt  covenant violation –Contract violation is costly, earnings management  may be low‐cost way to work around The Bad Side of Earnings  Management •Contracting Perspective –Healy (1985) ‐Reports evidence of management  use of accruals to maximize their cash bonuses The Bad Side of Earnings  Management •Financial Reporting Perspective –Argues investors and analysts look to core  earnings, ignoring provisions for non‐core  extraordinary and non‐recurring items –This implies manager not penalized for non‐core   provisions, such as writedowns, provisions for  restructuring –But current non‐core  provisions increase core  earnings in future years, through lower  amortization, and absorption of  future costs Recent examples of bad earnings  management •Groupon Inc., Theory in Practice 11.1 •Extreme income maximization •Capitalize marketing costs •Emphasize pro‐forma income Standard setters response to bad  earnings management •IAS 37 –Before recording a provision, payments must be  probable and capable of reliable estimation –Provision must be valued at fair value –No excess provision as a result of uncertainty –Provisions must be used only to absorb costs for  which provision originally set up •ASC 420‐10‐25 –No provision until liability incurred Can accountants help reduce bad  earnings management? •Ye s , if full disclosure of –Revenue recognition policies –Unusual, non‐recurring and extraordinary events •Enables investors to better evaluate earnings  persistence –Effect of previous writeoffs on current core  earnings •Hanna ( 1999) Conclusion •Earnings management can be good if used  responsibly •Full disclosure helps to control bad earnings  management