CGA-CANADA
ACCOUNTING THEORY & CONTEMPORARY ISSUES [AT1] EXAMINATION
March 2011
Time: 3 Hours
Marks
Note:
All references to the Handbook refer to the CICA Handbook.
30
Question 1
Select the best answer for each of the following unrelated items. Answer each of these items in your
examination booklet by giving the number of your choice. For example, if the best answer for item (a)
is (1), write (a)(1) in your examination booklet. If more than one answer is given for an item, that item will
not be marked. Incorrect answers will be marked as zero. Marks will not be awarded for explanations.
Note:
2 marks each
a.
Which of the following statements describes the effects of accounting for financial assets at fair value
through profit and loss under IAS 39?
1)
2)
3)
4)
Tends to increase the volatility of other comprehensive income
Tends to decrease the volatility of other comprehensive income
Tends to increase the volatility of net income
Tends to decrease the volatility of net income
b. Which of the following statements describes post-announcement drift?
1) Prices of good news firms tend to drift upwards and prices of bad news firms drift downwards for
60 days beyond the earnings announcement date.
2) Future earnings are more highly correlated with current cash flows than current accruals.
3) Noise traders are more active after good news announcements than after bad news
announcements.
4) Stock prices of firms announcing good earnings news increase and those of firms announcing bad
earnings news fall, surrounding the earnings announcement date.
c.
Which of the following statements describes the features of a first-best contract between a risk-averse
manager and a risk-neutral owner of an enterprise under direct monitoring?
1)
2)
3)
4)
The owner does not bear any risk and the manager bears all the risk.
The manager is never able to meet his or her reservation utility.
The owner bears all the risk and the manager does not bear any risk.
The manager is easily able to shirk.
d. Which of the following statements explains why firms with high levels of research and development
(R&D-intensive firms) exhibit a low level of association between net income and stock prices?
1) Net incomes of R&D-intensive firms are low, while stock prices react positively to the firms’
R&D activities.
2) R&D-intensive firms are low-risk firms.
3) R&D-intensive firms are high-growth firms.
4) R&D-intensive firms exhibit low recognition lags.
Continued...
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e.
Which of the following statements explains why accounting policy changes required by accounting
standards matter to management?
1)
2)
3)
4)
f.
New accounting policy rules affect net income.
New accounting rules lead to lower reliability of accounting numbers.
Managers do not believe markets are efficient.
New accounting rules interfere with existing contracts.
Hanna (1999) asserted that managers’ bonuses are often based on core earnings. Which of the
following statements reflects one implication of this assertion?
1) Managers have a tendency to reduce core earnings.
2) Managers have a tendency to delay recognizing revenue.
3) Managers have a tendency to incur excessive amounts of non-recurring charges in the current
period.
4) Managers have a tendency to increase operating earnings.
g. Which of the following statements describes what is meant by Positive Accounting Theory (PAT)?
1) PAT attempts to predict and explain the reasons why firms make income-increasing accounting
policy choices.
2) PAT attempts to predict and explain the reasons why firms make income-decreasing accounting
policy choices.
3) PAT attempts to predict and explain the reasons why firms make income-increasing as well as
income-decreasing accounting policy choices.
4) PAT attempts to predict and explain the effects of accounting policy choices on debt covenants
and managerial bonus plans.
h. Which of the following statements about Ball and Brown’s (1968) research is correct?
1) On average, the share prices of firms that reported higher earnings than the previous year did not
change over a 12-month period preceding the month of the earnings announcement.
2) On average, the share prices of firms that reported higher earnings than the previous year did not
change over a 12-month period following the month of the earnings announcement.
3) On average, the share prices of firms that reported higher earnings than the previous year
increased over a 12-month period preceding the month of the earnings announcement.
4) On average, the share prices of firms that reported higher earnings than the previous year
increased over a 12-month period following the month of the earnings announcement.
i.
Which of the following is a reason for differential market response to reported earnings?
1)
2)
3)
4)
j.
Beta
Causation
Earnings sensitivity
Prospect theory
Which of the following implications of the adoption of fair value accounting is consistent with the
stewardship role of net income?
1)
2)
3)
4)
Fair values enhance relevance of net income.
Fair values enhance sensitivity of net income.
Fair values reduce reliability of net income.
Gains and losses realized by using fair value accounting for available-for-trade securities are
recorded in other comprehensive income.
Continued...
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k. From an accounting perspective, there are two important assumptions in the capital asset pricing
model (CAPM). Which of the following is an important assumption of the CAPM?
1)
2)
3)
4)
l.
Transaction costs do not depend on share prices.
There is no inside information.
Financial statements are perfectly reliable.
Current share price is readily available and is completely accurate.
Under which of the following circumstances is the proportion of accounting-based performance
measures larger than the proportion of market-based performance measures in a company’s
managerial compensation plan?
1) When a short-term decision horizon is in the firm’s best interests
2) When a long-term decision horizon is in the firm’s best interests
3) When accounting-based performance measures are more sensitive than market-based performance
measures
4) When accounting-based performance measures are less precise than market-based performance
measures
m. Which of the following statements is consistent with the information approach to decision usefulness?
1) It measures usefulness by the extent of volume or price changes following the release of the
information.
2) It measures usefulness by the extent of changes in annual earnings to information content.
3) It measures usefulness by the extent of year-to-year changes in quarterly earnings to information
content.
4) It measures usefulness by the extent of changes in accounting policies to information content.
n. An efficient securities market is best described by which of the following statements?
1)
2)
3)
4)
The only significant risk factor is a firm’s beta.
All investors are rational.
All publicly available information is impounded in prices quickly.
Transaction costs equal zero.
o. Hobbes contemplated the consequences of living in a world without any morality. In this context,
what actions will banks take if they suspect that all borrowers manipulate their financial statements?
1)
2)
3)
4)
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Banks will refuse to lend.
Banks will reduce the interest rates charged on loans.
Banks will require borrowers to provide financial information using only fair value accounting.
Banks will hire fewer people for processing loan applications.
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14
Question 2
This question is based on the article entitled “Earnings Management,” which appeared in the
December 31, 2002 issue of CFO.com magazine. The article discusses the methods and reasons why
company managers undertake earnings management.
Required
4
a.
The article quoted Arthur Levitt, chair of the U.S. Securities and Exchange Commission (SEC), as
saying “I recently read of one major US Company that failed to meet its so called ‘numbers’ by one
penny and lost 5 percent of the value of its stock on one day.” The phrase “so called numbers” in
Levitt’s statement refers to the firm’s expected earnings per share for the period.
Calculate the firm’s earnings response coefficient using the information provided by Levitt. Assume
the following:



5
The market index did not change that day
The firm has a beta of one
The firm has an alpha of zero (in the market model)
b. The article states that earnings management practices are widespread and are aimed toward “meeting
earnings estimate [which] became something of a religion for corporate executives. It’s easy to
understand why, too: Many senior managers had their pay tied to share price performance.” The
phrase “meeting earnings estimates” refers to a situation where reported (or actual) earnings are
greater than expected earnings.
Discuss why managers whose pay is tied to a firm’s share price performance would want to report
earnings that are greater than expected earnings.
5
10
c.
The article reports that many firms are now improving their financial disclosure practices. It states that
many managers appear more interested in making sure that investors can trust their reported numbers.
Explain the effect of better disclosure quality on the cost of capital. Provide one explanation.
Question 3
The following questions are independent.
5
a.
Reliable financial statement information has several dimensions. Identify three dimensions of reliable
financial statement information and explain each of the three dimensions.
5
b. Ideal Inc. operates under ideal conditions of certainty. It has a capital asset that will generate $1,000
twice: first, at the end of the first year, and second, at the end of the second year of its operation. The
discount rate is 10%.
(3)
i)
(2)
ii) Calculate the net income of the firm for its second year of operation if the firm pays a $50
dividend at the end of the first year. Show calculations.
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Calculate and explain why the present value of future cash flows to the firm at the beginning of
the first year equals its market value under ideal conditions.
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14
Question 4
This question is based on the article entitled “To FASB or not to FASB” which appeared in The Economist
on June 10, 2010. The article discusses the differences in proposals published by the International
Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) regarding the
accounting treatment of financial instruments. The major difference between the two proposals concerns
the accounting treatment of loans made by banks. The IASB proposes that these loans, when held to
maturity, are recognized at historical cost, but the fair value of the loans would be disclosed in the
footnotes to the financial statements. The FASB wants changes in fair values of loans held to maturity to
be reflected in income.
Assume that the FASB proposal is adopted as U.S. GAAP.
Required
4
a.
The article states that “The crafting of accounting rules is more art than science, thanks to the need to
balance the interests of companies, their investors and — especially in banking — their regulators.”
Identify and discuss which theory of regulation this statement is consistent with.
5
b. The article provides information about the total carrying value (at cost) and the corresponding fair
value of loans issued by a number of U.S. banks. For example, The Regions Financial Bank (RFB)
shows carrying values of $83 billion and fair values of $70.2 billion, and the difference ($12.8 billion)
is 160% of its shareholders’ equity. The corresponding figures for Citigroup Bank are $670 billion
carrying value, $658 billion fair value, and the difference ($12 billion) is 10% of the bank’s
shareholders’ equity.
Discuss whether the application of the new FASB rule will have any effect on the ability of these
banks to raise funds by issuing bonds. Indicate which of the two banks will find it easier to raise funds
by issuing bonds. Assume that both banks have a minimum net worth covenant that requires them to
maintain a certain minimum amount of shareholders’ equity as a condition of the loan.
5
c.
Consider U.S. Bank A Inc., which records its loans at cost and discloses their fair values in the
footnotes. Now that the FASB proposal has become U.S. GAAP, Bank A has to change the
accounting treatment for its loans. Changes in fair values of loans to be held to maturity will now be
reflected in Bank A’s net income.
Assume that the CEO of the bank is paid a bonus as a percentage of net income. Discuss whether the
CEO will need a greater or smaller percentage of the net income as a bonus to maintain her
reservation utility, or if no change is expected as a result.
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12
Question 5
Two recent exposure drafts (EDs) issued by the Financial Accounting Standards Board (FASB) and the
International Accounting Standards Board (IASB) in May 2010 and November 2009, respectively, reflect
the different approaches taken by these two standard-setting bodies on accounting for loan assets. The
IASB ED suggests that gains and losses on loan assets are recognized in other comprehensive income or
reported in the notes to the financial statements. The FASB ED is recommending recognizing changes in
market values of loan assets in banks’ net income.
Required
4
a.
4
b. Some commentators have stated that these FASB fair value proposals for loans to be held to maturity
will not lead to transparency unless there is “one standard fair value” for each loan. Explain what
“standard fair value” means in this context. Indicate whether you agree with these commentators.
Briefly discuss the effect of “transparency” on reliability of accounting numbers.
4
c.
10
Compare and discuss the volatility of net income of a financial institution (for example, a bank)
calculated under the FASB standards versus the IASB standards.
Consider two banks, Bank B and Bank C, which are otherwise comparable, but Bank B (located in the
United States) follows FASB standards for recognizing changes in the market value of loan assets in
net income, and Bank C (located in Europe) follows the IASB standard of recognizing loan assets at
historical cost, thus ignoring changes in fair values of loan assets. Compare the sizes of predicted
lending portfolios for Banks B and C and discuss how the accounting standards would influence
lending practices.
Question 6
On February 15, 2011, ProCorp Inc. announced that its earnings per share for the next quarter is expected
to increase to 45 cents per share. ProCorp also released its financial results for the year ended
December 31, 2010 on the same date. The earnings per share in the prior quarter (ended
December 31, 2010) were 17 cents per share, exactly what analysts had forecasted for that quarter.
ProCorp supported its forecast about the next quarter by pointing out the success of its new product launch
and favourable product acceptance rates in new markets. At the end of trading on February 14, 2011,
ProCorp’s shares had increased 30% for the year to date.
On February 15, 2011, ProCorp’s shares opened the day on the stock exchange at $36 and closed at $41.
The stock exchange index increased 37 points on the day to close at 9,715. ProCorp’s beta is 1.9 and the
Bank of Canada rate on February 15, 2011 was 4.5%, or about 0.0001 per day.
Required
4
a.
2
b. Assuming the securities market is efficient, explain why ProCorp’s share price increased on
February 15, 2011.
4
c.
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Calculate the abnormal return of ProCorp’s shares for February 15, 2011. (Use the market model for
abnormal returns and use CAPM for calculating .)
Identify and explain two assumptions about individual investors that underlie the CAPM.
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10
Question 7
Nathaniel is planning to invest $100,000 for one year. There are two companies that interest Nathaniel but
he can only invest in one of them. Nathaniel is a rational, risk-averse investor with utility equal to the
square root of the net return on his investment. His choices are:
1. Action a1: Nathaniel invests $100,000 in Bikes Inc. shares.
2. Action a2: Nathaniel invests $100,000 in Cars Inc. shares.
Nathaniel’s payoff from these investments depends on the future price of gasoline. If the price of gasoline
is high, Nathaniel will earn a net return of $1,500 on Bikes shares and only $400 on Cars shares.
Alternatively, if the price of gasoline is low, Nathaniel will earn $1,000 on Cars shares and only $500 on
Bikes shares.
Nathaniel’s prior probability on the price of gasoline being high is 30%.
Required
3
a.
Determine which action Nathaniel should take based on his prior probabilities. Show calculations.
2
b. After undertaking extensive research, Nathaniel determines that gasoline refiners are expecting good
news. That is, gasoline refiners expect the price of gasoline to be high. Nathaniel has determined that
if future gasoline prices are going to be high, there is an 80% probability that gasoline refiners will
expect good news. Alternatively, if future gasoline prices are going to be low there is a 30%
probability that gasoline refiners will expect good news. Provide the information system, using a 2 × 2
matrix, that depicts this new information.
5
c.
Since gasoline refiners are expecting good news, determine whether Nathaniel should invest in Bikes
or Cars. Show your calculations.
END OF EXAMINATION
100
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ACCOUNTING THEORY & CONTEMPORARY ISSUES [AT1]
EXAMINATION
AT1
Before starting to write the examination, make sure that it is complete and that there are no
printing defects. This examination consists of 7 pages. There are 7 questions for a total of
100 marks.
READ THE QUESTIONS CAREFULLY AND ANSWER WHAT IS ASKED.
To assist you in answering the examination questions, CGA-Canada includes the following glossary of terms.
Glossary of Assessment Terms
Adapted from David Palmer, Study Guide: Developing Effective Study Methods (Vancouver: CGA-Canada, 1996).
Copyright David Palmer.
Calculate
Compare
Contrast
Criticize
Define
Describe
Design
Determine
Diagram
Discuss
Evaluate
Mathematically determine the
amount or number, showing
formulas used and steps taken. (Also
Compute).
Examine qualities or characteristics
that resemble each other. Emphasize
similarities, although differences
may be mentioned.
Compare by observing differences.
Stress the dissimilarities of qualities
or characteristics. (Also Distinguish
between)
Express your own judgment
concerning the topic or viewpoint in
question. Discuss both pros and
cons.
Clearly state the meaning of the
word or term. Relate the meaning
specifically to the way it is used in
the subject area under discussion.
Perhaps also show how the item
defined differs from items in other
classes.
Provide detail on the relevant
characteristics, qualities, or events.
Create an outcome (e.g., a plan or
program) that incorporates the
relevant issues and information.
Calculate or formulate a response
that considers the relevant
qualitative and quantitative factors.
Give a drawing, chart, plan or
graphic answer. Usually you should
label a diagram. In some cases, add
a brief explanation or description.
(Also Draw)
This calls for the most complete and
detailed answer. Examine and
analyze carefully and present both
pros and cons. To discuss briefly
requires you to state in a few
sentences the critical factors.
This requires making an informed
judgment. Your judgment must be
shown to be based on knowledge and
information about the subject. (Just
stating your own ideas is not
sufficient.) Cite authorities. Cite
advantages and limitations.
Explain
In explanatory answers you must
clarify the cause(s), or reasons(s).
State the “how” and “why” of the
subject. Give reasons for differences
of opinions or of results. To explain
briefly requires you to state the
reasons simply, in a few words.
Identify
Distinguish and specify the important
issues, factors, or items, usually based
on an evaluation or analysis of a
scenario.
Illustrate
Make clear by giving an example,
e.g., a figure, diagram or concrete
example.
Interpret
Translate, give examples of, solve, or
comment on a subject, usually
making a judgment on it.
Justify
Prove or give reasons for decisions or
conclusions.
List
Present an itemized series or
tabulation. Be concise. Point form is
often acceptable.
Outline
This is an organized description. Give
a general overview, stating main and
supporting ideas. Use headings and
sub-headings, usually in point form.
Omit minor details.
Prove
Establish that something is true by
citing evidence or giving clear logical
reasons.
Recommend Propose an appropriate solution or
course of action based on an
evaluation or analysis of a scenario.
Relate
Show how things are connected with
each other or how one causes another,
correlates with another, or is like
another.
Review
Examine a subject critically,
analyzing and commenting on the
important statements to be made
about it.
State
Clearly provide a position based on
an evaluation, e.g., Agree/Disagree,
Correct/Incorrect, Yes/No. (Also
Indicate)
Summarize Give the main points or facts in
condensed form, like the summary of
a chapter, omitting details and
illustrations.
Trace
In narrative form, describe progress,
development, or historical events
from some point of origin.
CGA-CANADA
ACCOUNTING THEORY & CONTEMPORARY ISSUES [AT1] EXAMINATION
March 2011
SUGGESTED SOLUTIONS
Marks
30
Time: 3 Hours
Question 1
Note:
2 marks each
Sources/Explanations:
a.
3) Topic 5.5 (Level 1)
As the definition suggests, these are financial assets that affect net income and thus do not affect
other comprehensive income. Thus, options 1) and 2) are incorrect. If financial assets are at fair
value through profit and loss, this will increase and not decrease net income volatility. Thus,
option 4) is incorrect.
b. 1) Topic 5.2 (Level 1)
Option 2) is not post-announcement drift and the factual content of this statement is still under
debate. Option 3) is not post-announcement drift either. Option 4) is not post-announcement drift;
it is simply a manifestation of market efficiency.
c.
3) Topic 7.3 (Level 1)
The owner bears all the risk and the manager none in a first best contract under direct monitoring.
This happens because under direct monitoring, the owner can observe the manager’s actions and
thus there is no moral hazard. The manager can be paid a salary and has no risk. The owner bears
all the risk. Thus, option 1) is incorrect. If the manager’s salary is adequate, then he can meet his
reservation utility. Thus, option 2) is incorrect. The manager cannot shirk because he is subject to
direct monitoring. Thus, option 4) is incorrect.
d. 1) Topic 5.2 (Level 1)
Expensing of R&D expenditure reduces net income, but if the stock market reacts positively to
the future cash flow potential of R&D activities then the association between net income and
prices will be low. Options 2) and 3) are incorrect because low-risk and high-growth firms tend to
have a high, not low, association between net income and prices. Option 4) is incorrect because
the recognition lag is high, not low, for R&D intensive firms.
e.
4) Topic 6.5 (Level 1)
New accounting rules lead to changes in accounting numbers and thus might affect existing
contracts such as compensation or debt contracts. Managers are motivated to avoid the adverse
effects of these new rules, if any, on existing contracts. Thus, new accounting rules matter to
managers. Option 1) is an inferior answer to option 4) because managers will react to changes to
net income for a reason, and option 4) indicates one set of possible reasons for managers to react
to new accounting rules. Option 2) is incorrect because loss of reliability in net income, if any,
arising from new rules may reduce the quality of earnings, but there must be a reason why
changes in quality of earnings matter to managers and option 2) does not indicate that. Option 4)
is still a better answer. If managers do not believe that markets are efficient then it should not
matter to them for investment reasons. Option 4) provides the contractual reason. Thus, option 3)
is incorrect.
Continued...
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Page 1 of 7
f.
3) Topic 8.10 (Level 1)
By incurring excessive amounts of non-recurring charges in the current period, managers will
artificially inflate future core earnings and hence future bonuses. Options 1) and 2) are incorrect
because they both decrease bonuses. Option 4) is incorrect because increasing operating earnings
might not necessarily increase core earnings.
g. 3) Topic 6.4 (Level 1)
PAT attempts to explain and predict accounting policies using one of the three hypotheses,
namely, the bonus plan, debt covenant, and political cost hypotheses. The accounting policies
could be income increasing or income decreasing. Thus, options 1) and 2) are incorrect. Option 4)
is incorrect because the argument is reversed here. PAT attempts to explain the effects of debt
covenants and bonus plan on accounting policies and not the other way around.
h. 3) Topic 4.2 (Level 1)
Ball and Brown showed that firms reporting higher earnings than in the previous year enjoyed
increases in share price over a period of 12 months preceding the earnings announcement. The
other answers are incorrect.
i.
1) Topic 4.3 (Level 1)
The higher the beta the lower the market response to reported earnings or earnings response
coefficient (ERC). Causation refers to a setting where a change in one variable or event causes the
change in another variable or event. This is not a reason for differential market response. Earnings
sensitivity is the effect of managerial effort on earnings. This might be distantly related to ERC,
but option 1) is the better answer. Prospect theory is an alternative to rational decision theory in
which investors view gains and losses differently. This is not related to ERC. Thus, option 4) is
incorrect.
j.
2) Topic 8.3 (Level 1)
Sensitivity is the extent to which managerial effort is realized in net income as the performance
measure, which is an important managerial stewardship role. Options 1) and 3) relate to the
investment decision role of accounting numbers and are thus incorrect. Option 4) has nothing to
do with the managerial stewardship role of fair value accounting and is incorrect.
k. 2) Topic 3.4 (Level 1)
It is assumed that beta is known and that there is no inside information. Inside information
imposes risk in addition to beta. Option 1) is incorrect because CAPM assumes zero transaction
costs and not constant (or non-zero) transaction costs. Only with zero transaction costs can
rational investors fully diversify, so that beta is the only relevant risk measure. Option 3) is
incorrect because CAPM does not rely on any information that is exclusively available in
financial statements. Option 4) is incorrect because CAPM does not require a current share price
to be available.
l.
1) Topic 8.3 (Level 1)
Research has shown that it is possible to control a manager’s decision horizon by adjusting the
proportion of accounting-based (such as bonus plans) versus market-based performance measures
(such as ESOs) in a managerial compensation plan. By focusing on short-term accounting
performance targets, it is possible to motivate managers to strive to achieve the short-term goals
of the firm. Thus, option 2) is incorrect. Options 3) and 4) are backwards. Accounting-based
performance measures are less sensitive and more precise than market-based performance
measures.
Continued...
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m. 1) Topic 4.1 (Level 1)
Investors gather information to predict future returns on their investment decisions. If accounting
information is useful, investors would make buy-hold-sell decisions based on that information,
and this would result in security price changes. Options 2), 3), and 4) are changes in accounting
numbers and do have information, but that is not the information perspective because earnings lag
share prices. Option 1) is the best answer because it refers to volume and price changes.
n. 3) Topic 3.1 (Level 1)
An efficient stock market in the semi-strong form is a market where all public information is
incorporated in prices quickly. Option 1) is incorrect because there is evidence that risk factors
such as firm size and book-to-market ratio also affect share return. Option 2) is incorrect because
there are noise or equity traders in the market whose portfolio choice decisions are not totally
based on rational decision theory, such as maximization of expected utility. Option 4) is incorrect
because transaction costs do not preclude a market from being efficient.
o. 1) Topic 2.8 (Level 2)
Under conditions of no morality, banks will probably stop lending. Option 2) is incorrect because
banks will more likely raise interest rates if manipulation is suspected. Option 3) is incorrect
because fair value accounting provides even greater opportunities for manipulation. If the banks
stop lending, as option 1) suggests, they will need fewer employees. Thus, option 4) is dominated
by option 1). On the other hand, if banks continue to lend, they will need more loan officers (and
not less) to exercise greater scrutiny of suspected manipulated financial statements. Thus,
option 4) is incorrect.
14
Question 2
Source: Topics 4.3, 8.9, and 9.2 (Levels 1 and 2)
4
a.
Earnings response coefficient = Abnormal returns / Unexpected earnings
Abnormal returns = Actual returns – ( +  × Market returns)
Actual returns = –0.05,  = 0,  = 1
Abnormal returns = –0.05
Unexpected earning = –0.01
ERC = –0.05 / –0.01 = 5 per dollar of unexpected earnings
5
b. If reported earnings are greater than forecasted or predicted or expected earnings, share prices will
rise. If, on the other hand, reported earnings are less than expected earnings, share prices will fall.
Changes in share prices will change the value of the executive stock options held by managers. The
higher the price, the greater the profit the manager earns from exercising the option. Thus, managers
are keen to ensure that reported earnings exceed forecasted earnings.
5
c.
There are a number of reasons why better disclosure helps firms achieve higher stock prices:

Better disclosure leads to lower information asymmetry and this facilitates trading by institutional
investors because of higher liquidity as a result of lower information asymmetry. This increases
demand for the shares and raises share prices and conversely lowers the cost of capital.

Better disclosure also reduces investor concerns about potential insider trading and will increase the
demand for the shares. This will increase share prices and thus lower the cost of capital. (This
answer is a variant of the previous answer.)

Better disclosure also might increase the number of informed investors in the market. This will
increase the degree of diversification of the share and reduce its cost of capital, leading to increased
prices.
Note:
Only one of the three answers is required for full marks.
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10
Question 3
Source: Topics 1.4 and 1.5 (Level 1)
a.
5
Representational faithfulness. A correspondence between the accounting valuation or description of
an item and the real item the information represents.
Freedom from bias. No influence or prejudice has resulted in altered values. For example, an
accounting valuation is biased if management manipulates the valuation for its own purposes.
Verifiability. Different accountants and auditors should be able to independently arrive at the same
value if the information is verifiable.
5
(3)
b.
i)
(2)
The present value of the firm at the beginning of the first year at t = 0 is = 1,000 / 1.1 + 1,000 /
1.21 = $1,735.54. The owner of the firm will not sell the firm for less than $1,735.54 because he
will earn less than 10% if he sells for less. The buyer will not pay more than $1,735.54 because
she could have earned more by keeping the funds with herself. If she buys the firm for $2,000, for
example, she will get only 10% of $1,735.54 or $173.55, and she could have received 10% of
$2,000 or $200 if she kept the cash and did not use it to buy the asset. Thus, the demand and
supply will equate only at $1,735.54, which is the market value of the firm.
ii) PV (at t = 1) = 1,000 / 1.10 = $909.90 = Amortization for year 2
NI for second year = ($1,000 – $909.09 + [10% interest on ($1,000 – $50)]
= $90.91 + $95.00
= $185.91
14
Question 4
Source: Topics 6.4, 7.3, 7.4, and 10.1 (Level 1)
4
a.
This statement is consistent with the interest group theory of regulation, which states that regulation is
the product of compromise between the needs of a number of pressure groups or constituencies in the
industry and the economy. One of the important features of this theory is that the regulator constitutes
an interest group, which is what is indicated in this statement.
Note:
A superior answer will identify all 3 groups (FASB, IASB, regulators) as interest groups.
5
b. The Regions Financial Bank will find it harder to raise bonds as compared to Citigroup Bank. Its net
worth covenant would have been violated as a result of the new rule and it would have to renegotiate
the conditions (covenants) of the loan. It will be hard for this bank to borrow more money by issuing
bonds. The situation is not so dire for the other bank.
5
c.
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The net income of the U.S. bank, Bank A, will become more volatile as a result of the application of
the rule. If the CEO’s pay is linked to net income, her compensation risk will increase. She will
require a greater proportion of the bank’s net income to maintain her reservation utility.
©CGA-Canada, 2011
Page 4 of 7
12
Question 5
Source: Topics 4.5, 5.5, and 6.4 (Levels 1 and 2)
4
a.
As the market value of the loan changes over time, the unrealized gains and losses will be recognized
in net income under FASB rules. This will introduce volatility in net income. However, under IASB
standards, these changes in the value of the loan will not be recognized in net income. Thus, net
income is less volatile under IASB.
4
b. In this case, “one standard value” means that the market value of the loan can be determined without
any ambiguity. Sometimes, market values are not known unambiguously. For example, present value
calculations might have to be made and this leads to application of judgment by the manager, and the
decision of the manager could be biased or erroneous. The market value number will depend on the
assumptions made by management. This will lead to loss of reliability. Transparency is related to
reliability. The more reliable the number, the more transparent it is for the given relevance.
Note:
Give full marks if the student explains that managers need to estimate market values.
4
c.
Bank B (the U.S. bank) would likely make fewer loans than the European counterpart. For example,
U.S. banks will not make loans that have a greater risk of default. As default risk increases, the value
of the loan will fall and the bank will have to write the loan down, leading to fluctuations in its net
income. Even if the value of the loan recovers later, this will increase volatility in its net income,
which increases the probability of the bank violating its debt covenant and makes managerial bonuses
more risky. U.S. banks will attempt to avoid these adverse consequences of net income volatility by
issuing fewer loans. Thus, the size of the lending portfolio of Bank B will likely be smaller than
Bank C.
Note:
To get full marks, students need to explain: i) the relative effects of the two rules on net income volatility and ii) the consequences of
this increased volatility.
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10
Question 6
Source: Topics 3.1 and 3.4 (Level 1)
4
a.
Using the market model:
Rjt = αj + βjRMt + ϵt
Rjt = 5 / (41 – 5) = 5 / 36 = 0.1389
αj = 0.0001 × (1 – 1.9) = 0.0001 × (–0.9) = –0.00009
RMt = 37 / (9,715 – 37) = 37 / 9,678 = 0.0038
The abnormal return is:
ϵt = 0.1389 – [–0.00009 + (1.9 × 0.0038)]
= 0.1389 – (–0.00009 + 0.00722)
= 0.1318 or 13.18%
2
b. ProCorp forecast that profits and earnings per share would increase next quarter. This forecast was
supported by information about the success of the new product and its high acceptance rates. The
forecast of increased future profits constituted new information to the investors and the efficient
market reacted by increasing prices.
4
c.
The market model assumes:
1. Individual investors are rational. In making decisions, the chosen action is the one that yields the
highest expected utility.
2. Individual investors are risk averse. Risk aversion is the reluctance of a person to accept an action
with an uncertain payoff rather than another action with a more certain, but an equal or even
possibly lower, expected payoff.
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10
Question 7
Source: Topic 2.2 (Level 1)
3
a.
EU(a 1 )  0.3 1,500  0.7  500
= 0.3 × 38.73 + 0.7 × 22.36
= 27.27
EU(a 2 )  0.3 400  0.7  1,000
= 0.3 × 20 + 0.7 × 31.62
= 28.14
Therefore, Nathaniel should take action a2 and purchase Cars Inc. shares as its expected utility is
higher.
2
b.
Refiners’ Information
Good News
Bad News
High
0.8
0.2
Low
0.3
0.7
State
5
c.
Using Bayes’ theorem:
P(H / GN ) 
0.3  0.8
0.24

 0.53
0.3  0.8  0.7  0.3 0.45
P(L / GN) = 1.00 – 0.53 = 0.47
Nathaniel’s expected utility of each action is now:
EU(a 1 )  0.53 1,500  0.47 500
= 0.53 × 38.73 + 0.47 × 22.36
= 31.03
EU(a 2 )  0.53 400  0.47 1,000
= 0.53 × 20 + 0.47 × 31.62
= 25.46
Therefore, Nathaniel should now choose a1 and invest in Bikes Inc. because it has a higher expected
utility.
END OF SOLUTIONS
100
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CGA-CANADA
ACCOUNTING THEORY & CONTEMPORARY ISSUES [AT1] EXAMINATION
March 2011
EXAMINER’S COMMENTS
General Comments
Some students had difficulty with this AT1 examination, demonstrating a lack of understanding, or in
some cases awareness, of important course concepts such as calculation of expected utility and theories of
regulation. Many students had difficulty applying course material to real-world situations (Questions 2
and 6).
Numerous students did not know formulae for CAPM and Bayes’ theorem. Knowledge of short formulas
such as these helps in understanding and applying them. These formulas will not always be given as part
of the question.
Specific Comments
Question 1 Multiple choice (Levels 1 and 2)
Overall performance on this question was unsatisfactory, although there were a number of students
received excellent marks.
Question 2 Earnings management (Levels 1 and 2)
Performance on this question was unsatisfactory.
a.
This question required knowledge of the CAPM (although the question simplified the formula
considerably by stating α = 0, β = 1, with no change in the market index). Nevertheless, many students did
not complete this part.
b. This part was reasonably answered by most students. It was generally recognized that exceeding earnings
expectations results in a rise in share price. Where marks were lost, it was usually because of a too-brief or
incomplete discussion of why. A more complete answer would indicate that, when earnings exceed
expectations, share price rises because rational investors increase their probabilities of high future firm
performance, and go on to point out that a rise in share price increases the value of stock options held by
the manager. Questions that ask students to “discuss” require a detailed answer.
c.
This part was also reasonably answered. However, many answers were vague. For example, some
students simply said that more investor trust lowers cost of capital. This is correct, but an explanation of
why was also required. A good explanation is that greater trust lowers investors’ concerns about inside
information and adverse selection, and thus lowers estimation risk. The “lemons” model then indicates
that share price will rise or, equivalently, that cost of capital falls.
Question 3 Reliability; Ideal conditions; Present value of future cash flows (Level 1)
Performance on this question was satisfactory.
a.
Most students knew the three components of reliability. However, explanations of
representational faithfulness tended to be vague. The correct explanation is that to be
representationally faithful the valuation or description of the accounting item should correspond
with reality. Nevertheless, a variety of reasonable explanations were accepted.
Continued...
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©CGA-Canada, 2011
b. i)
The numerical portion of this part was well answered. However, few students gave an adequate
explanation of why present value and market value are equal under ideal conditions. A full
explanation would outline the process of arbitrage under which, the moment market value does
not equal present value, investors would earn arbitrage profits by buying or selling shares in the
firm, until equality is restored.
b. ii) Several students missed the $95 of interest earned in year 2 on opening cash. A few students
attempted to calculate net income for year 1, whereas year 2 was asked for.
A number of students incorrectly treated the $50 of dividends paid as a deduction in determining net
income. This type of error should not be made at this level of the CGA program.
Question 4 Accounting treatment of loans made by banks (Level 1)
Performance on this question was satisfactory.
a.
This part was generally well answered, although some students seemed to be unaware of the two
theories of regulation.
b. This part was well answered by most students.
c.
Most students recognized the key point in this part, that fair valuing loans in net income increases
earnings volatility. There is no effect on expected net income since fair value is just as likely to rise as
to fall. It is also crucial to realize that greater net income volatility decreases the manager’s expected
utility of bonus compensation, hence the need for a higher percentage of net income to maintain
reservation utility. It is not correct to suggest, as several students did, that reservation utility falls.
Reservation utility is treated as a constant in a one-period context such as this question. Reservation
utility will only change as the manager’s reputation rises or falls over time. Changes over time in
reservation utility are beyond the scope of AT1. In addition, some students suggested that part of the
compensation should be allocated to a performance measure other than net income.
Question 5 Loan assets (Levels 1 and 2)
Performance on this question was satisfactory.
a.
This part was well answered by most students.
b. This part was well answered by most students. However, some students simply stated that they agreed
with the commentator, but did not provide a rationale.
c.
This part was generally well answered, although a number of students missed the point. The point is
that greater volatility of loan values creates net income volatility. Banks dislike volatility since they
like to report steady, and steadily increasing, earnings, both to create an impression of solidity in the
minds of investors (recall empirical evidence that the stock market rewards firms that report steadily
increasing earnings), and to reduce the likelihood of violating debt covenants.
A few students did not state a conclusion as to which bank would have the smaller loan portfolio.
Students must be sure to read the question carefully. In addition, a few students responded from the
perspective of an investor in terms of both banks, instead of answering the question asked.
Continued...
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Question 6 Abnormal returns; CAPM (Level 1)
Performance on this question was unsatisfactory.
a.
There were numerous errors in answering this part, due mainly to lack of knowledge of the CAPM
formula and/or using the annual interest rate rather than the daily rate. Part marks were awarded where
appropriate.
b. This part was well answered by most students. To their credit, most students realized that the market
had already reacted to the increase the increased earnings for the quarter, since it equalled the
analysts’ forecast. The share price rise was due to the new information in the management forecast.
c.
This part was well answered by most students. However, a number of students did not read the
question properly, giving assumptions about the CAPM rather than about investors.
Question 7 Single-person decision theory (Level 1)
Performance on this question was unsatisfactory.
a.
This part was well answered by most students, although some students had difficulty calculating
expected utility. In particular, some students put the probabilities inside the square root sign.
b. Those students who understood the information system concept received full marks. Those who did
not were awarded part marks if one diagonal was correct. Note that information system probabilities
add to 1 going across the information system table. That is, for each possible state of nature, the
probabilities add to 1.
c.
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Again, those students who knew the Bayes’ theorem formula usually did well. Those who did not did
poorly, although part marks were awarded where appropriate.
©CGA-Canada, 2011