CGA-CANADA

ACCOUNTING THEORY & CONTEMPORARY ISSUES [AT1] EXAMINATION

March 2010
Marks Time: 3 Hours

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. Several researchers have documented that financial analysts revise, from time to time, their forecasts
of a firm’s earnings for a particular future period. For example, in January 2009, an analyst predicts
(forecasts) that 2010 earnings of ABC Company will be $1 per share. Three months later, the analyst
revises ABC’s 2010 earnings forecasts to $1.05 per share. Researchers have observed that when
analysts change (revise) future earnings forecasts, the firm’s share prices also change. Which of the
following statements best describes an implication of the effect of analyst’s earnings forecast revisions
on share prices?
1) Markets are inefficient.
2) Analysts’ earnings forecasts are highly persistent.
3) Analysts’ earnings forecasts reflect the market’s earnings expectations.
4) Analysts’ earnings forecasts cause firms to change their operating policies.

b. Which of the following statements explains why efficient securities market anomalies continue to
persist over time?
1) Because of the high cost of investment strategies to exploit the anomalies
2) Because of the activity of noise traders, whose decisions to trade are not based on rational
evaluation of information
3) Because financial information available to investors is not both completely relevant and
completely reliable
4) Because many securities in which the anomalies are concentrated trade frequently

c. Standard setters are slowly moving in the direction of quantitative risk reporting by different firms,
signifying a move towards the measurement perspective in the case of disclosure. One example of
quantitative risk reporting is known as “value at risk,” which is best described by which of the
following statements?
1) It is the estimate of the proportion of the value of total employee stock options of a firm that is
subject to high risk.
2) It is the estimate of the loss in earnings, cash flows, or fair values that can result from a large
change in prices, but that has a low probability of occurring.
3) It is the estimate of the proportion of the value of the total assets of the firm that is subject to high
risk.
4) It is the estimate of the share price volatility of the firm.

Continued...

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 d. Which of the following statements explains why Beaver (1973) argues that specific accounting
policies used by a firm do not matter in an efficient market?
1) New accounting standards are being adopted all the time.
2) Firms have incentive to signal inside information credibly by using accounting policies.
3) The market can interpret information from any source.
4) Accounting policies can affect management stewardship decisions.

e. Price protection is an important feature of efficient markets. Which of the following statements
reflects what is meant by price protection in an efficient market?
1) Security prices reflect publicly known information.
2) All public information is relevant and reliable.
3) Investors in an efficient market can take out insurance policies to protect their investments in
securities from a fall in their prices.
4) Rational investors are consistently able to identify winners and losers in an efficient market.

f. According to Lambert and Larcker (1987), under which of the following situations does ROE (net
income divided by shareholders’ equity) tend to have a low weight relative to share-based awards,
such as stock options, in managerial compensation plans?
1) When the correlation between ROE and stock returns is zero
2) When the correlation between ROE and beta risk is zero
3) When the firm has experienced low growth
4) When the firm has experienced high growth

g. There has been a renewed interest in revenue recognition practices since the accounting scandals in
the 1990s relating to premature revenue recognition. Which of the following best describes the timing
of revenue recognition under different accounting bases?
1) Current value accounting implies early revenue recognition. Cash flow accounting implies late
recognition. Historical cost is in between.
2) Current value accounting implies late revenue recognition. Cash flow accounting implies early
recognition. Historical cost is in between.
3) Current value accounting implies early revenue recognition. Historical cost implies late
recognition. Cash flow accounting is in between.
4) Current value accounting implies late revenue recognition. Historical cost implies early
recognition. Cash flow accounting is in between.

h. The present value model is widely used in economics and finance and has had considerable impact on
accounting over the years. In the present value model under certainty, the amount called “accretion of
discount” is best described as which of the following?
1) The opening value of net assets multiplied by one plus the risk-free interest rate
2) The opening value of net assets multiplied by the risk-free interest rate
3) The closing value of net assets multiplied by one plus the risk-free interest rate
4) The opening value of net assets divided by the risk-free interest rate

i. Reliable financial statement information has several dimensions. Which of the following lists best
identifies these dimensions?
1) Representational faithfulness, relevance, and verifiability
2) Present value, ideal conditions, and verifiability
3) Representational faithfulness, freedom from bias, and verifiability
4) Present value, freedom from bias, and verifiability

Continued...

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 j. An investor’s utility function is given by U(x) = √x,  x 0. Which of the following best describes the
investor’s risk preferences?
1) Risk seeking
2) Risk neutral
3) Risk averse
4) Risk seeking across relatively small expected payoffs and risk averse across relatively large
expected payoffs

k. Which of the following best describes the theory of investment?

1) An application of agency theory to model the decision processes of a rational investor
2) An application of efficient markets theory to model the decision processes of a rational investor
3) An application of utility theory to model the decision processes of a rational investor
4) An application of decision theory to model the decision processes of a rational investor

l. In the theory of investment there are firm-specific factors that affect the return for only one firm.
Which of the following is an example of a firm-specific factor?
1) A new patent
2) Foreign exchange rates
3) Oil prices
4) Interest rates

m. The principle of diversification leads to an important risk measure in the theory of investment,
namely, beta risk. Which statement accurately describes beta?
1) Beta is used as proxy for the firm-specific risk of a security.
2) Beta is a measure of the systematic risk of a security.
3) Beta measures the volatility in the price of a security.
4) By definition, the beta of the market portfolio is 0.

n. An efficient securities market is often defined as a market in which prices of securities traded on that
market at all times fully reflect all information that is publicly known about those securities. Which of
the following describes this type of efficient market?
1) Strong-form efficient market
2) Semi-strong-form efficient market
3) Semi-weak-form efficient market
4) Weak-form efficient market

o. Which of the following statements correctly reflects the difference between rules-based accounting
standards and principles-based accounting standards?
1) The application of rules-based accounting standards is more reliant on an auditor’s professional
judgment compared to principles-based accounting standards.
2) The application of principles-based accounting standards is more reliant on an auditor’s
professional judgment compared to rules-based accounting standards.
3) Fair value accounting is an example of rules-based accounting standards and not principles-based
standards.
4) Historical cost accounting is an example of principles-based accounting standards and not
rules-based standards.

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15 Question 2
5 a. A number of researchers have found that earnings response coefficients (ERCs) increase with earnings
persistence. Explain why earnings response coefficients and earnings persistence are related. In
answering this question, first define what is meant by earnings response coefficients.

5 b. Compare the persistence of earnings resulting from the following two scenarios representing good
news in earnings. In both scenarios, the firm experiences the same amount of good news. Explain
under which of the following scenarios you would expect earnings persistence to be greater:
i) A firm experiences an increase in earnings over the previous year because it has been able to
achieve a permanent increase in its market share.
ii) A firm experiences an increase in earnings over the previous year because of an unanticipated
gain on sale of assets.

5 c. Indicate in which of the following scenarios earnings persistence will be greater. Discuss.
i) When an increase in earnings is achieved by an increase in cash flows from operations
ii) When an increase in earnings is achieved by an increase in net accruals

16 Question 3
A recent article entitled “Buying on the Dips,” published in the May 9-15, 2009 issue of The Economist
magazine, highlighted some costs and benefits that arise from merger and acquisition activities. Quite
often there are significant synergies between the two companies, and as a result there are often significant
savings in costs and capital expenditures. For example, when two firms enjoy an existing relationship,
there are benefits from merging their activities. This results in avoiding duplications and results in cost
savings. Capital investment is also optimized when the operations of both firms are considered together.

Consider the case of Firm A, a brewery company that is contemplating the acquisition of Firm B, another
brewery company. The managers of Firm A estimate that if A acquires B, the resulting merger will result
in cost savings of $2 million and capital expenditure savings of $20 million due to synergies between the
two firms. However, in order to pay for the purchase, the merged firm, AB, will have an additional debt of
$50 million on its balance sheet.

Assume that Firm AB will depreciate its capital assets, on average, over a period of 10 years. Assume that
the interest rate in the economy is 7% per annum.

Required
6 a. Estimate the effect of the cost savings, capital expenditure savings, and additional debt on Firm AB’s
net income in the first post-merger period. Ignore taxes.

10 b. Assume that managers of Firm A are compensated by a bonus plan linked to income. Explain whether
managers of Firm A would have any incentives to undertake the acquisition in terms of the positive
accounting theory under the following assumptions:
(5) i) The bonus plan has a bogey and a cap.
(5) ii) The bonus plan has no cap and the bogey is set at 0.

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15 Question 4
In recent years, a number of authors have documented questionable practices in relation to firms awarding
executive stock options (ESOs) to their senior managers.

For example, Aboody and Kasznik (2000) examined earnings announcement policies of firms that have
scheduled ESO grant dates. That is, these firms announced ESO grants on the same day every year. These
authors found that the firms with scheduled grant dates made early announcements of impending bad news
(BN) earnings reports, but did not make any early announcements of good news (GN) earnings reports.
Bad news earnings reports here refers to reported earnings being less than expected earnings, while good
news refers to reported earnings being greater than expected earnings.

Note that this practice was prevalent while Accounting Principles Board Opinion 25 (APB 25) was in
effect, which required the intrinsic value of the ESO to be used as the ESO expense. Most firms set the
exercise price of ESOs as the stock price of the granting firm on the date of the grant.

Required
5 a. Explain why the earnings announcement practice described above is considered an abuse of ESOs. In
answering this question, explain how managers stand to benefit unfairly from this practice, that is,
announcing only impending bad news (but not impending good news) just prior to the ESO grant date.

10 b. Another abuse of ESOs has been described as “late timing.” Consider the case of ABC Inc., which
sets the exercise price of its ESO equal to the stock price on the day the ESOs are granted. The board
of directors of ABC decided to grant 100,000 ESOs to its CEO on August 10, 2003, when the
prevailing stock price of the company was $20. However, the board also decided that the company
would report (falsely) that these 100,000 ESOs to its CEO were granted on July 15, 2003, when the
price of ABC stock was $15. In other words, the board of directors of ABC decided to lie about the
date on which the decision to grant the ESOs was made. No other ESOs were granted in 2003.

Eventually, investigations by the Securities and Exchange Commission (SEC) revealed these
foregoing decisions of ABC. ABC was compelled to restate its ESO expense to the correct amount.

Note that the APB 25 was in effect in 2003, under which firms used intrinsic value of ESOs as the
ESO expense.
(3) i) Determine the reported ESO expense of ABC for 2003 before restatement.
(3) ii) Determine the restated ESO expense of ABC for 2003 as a result of SEC investigations.
(4) iii) Explain why the practice of late timing is not consistent with GAAP.

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14 Question 5
Dan owns a medium-sized business, which, over the years, has generated some profits. Now he wishes to
hire a manager to run the business.

From his previous experience, Dan knows that if the manager works hard, there will be a cash flow of
$500 with a probability of 70% and a cash flow of $272 with a probability of 30%. On the other hand, if
the manager shirks, there will be a cash flow of $500 with a probability of 30% and a cash flow of $272
with a probability of 70%.

Dan is aware that the manager has to be paid a part of the cash flows in order to motivate him or her to
work hard. But the cash flows will take two years to materialize, while the manager will want some salary
at the end of the first year on the job.

At the end of the first year, it is possible to come up with a performance measure, referred to as “net
income,” and the manager who is hired can be paid a fraction of net income.

Dan knows from previous experience that if cash flows are $500, then net income will be $576 with
probability 80% and $196 with probability 20%. On the other hand if cash flows are $272, then net income
will be $576 with probability 20% and $196 with probability 80%.

Dan has interviewed Anushka and he feels Anushka will be a good candidate for the position of the
manager. Anushka has square root utility and has disutility of effort of 7 if she works hard and 6 if she
shirks. Anushka’s reservation utility is 3.

Required
6 a. Calculate what percentage of net income Dan should offer Anushka to make her work hard.

4 b. Verify that Anushka will work hard when offered this percentage and not have the incentive to shirk.

4 c. Having accepted the position, Anushka realizes that she can opportunistically manage income so that
whatever happens, she can report a net income of any amount not exceeding $576. Explain whether
Anushka will work hard or shirk under these circumstances.

10 Question 6
6 a. One way to characterize information production is credibility of information.
(2) i) Define what is meant by credibility of information.

(4) ii) It has been suggested that audits performed by the Big Four accounting firms are more credible
than audits performed by non-Big Four accounting firms. Explain the arguments put forward to
support this point of view.

Note:
The Big Four firms are PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young, and KPMG.

4 b. Jensen and Meckling (1976) have examined the incentive to produce information for a firm’s
owner-manager who intends to take the firm public by selling all or some shares to outside investors.
These authors suggest the owner-manager might voluntarily agree to submit the firm’s financial
statements to an independent audit in order to minimize agency costs.

Discuss the reasons why the owner-manager might agree to an independent audit voluntarily under the
circumstances described above.

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 6 pages. There are 6 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 Mathematically determine the
amount or number, showing
formulas used and steps taken. (Also
Compute).
Compare Examine qualities or characteristics
that resemble each other. Emphasize
similarities, although differences
may be mentioned.
Contrast Compare by observing differences.
Stress the dissimilarities of qualities
or characteristics. (Also Distinguish
between)
Criticize Express your own judgment
concerning the topic or viewpoint in
question. Discuss both pros and
cons.
Define 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.
Describe Provide detail on the relevant
characteristics, qualities, or events.
Design Create an outcome (e.g., a plan or
program) that incorporates the
relevant issues and information.
Determine Calculate or formulate a response
that considers the relevant
qualitative and quantitative factors.
Diagram 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)
Discuss 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.
Evaluate 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.
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 2010
SUGGESTED SOLUTIONS

Marks Time: 3 Hours

30 Question 1
Note:
2 marks each
Sources/Explanations:
a. 3) Topic 4.3 (Level 1)
The finding that analysts’ revisions of firms’ future earnings forecasts are associated with share
price changes implies that analysts’ earnings forecasts are proxies for the market’s earnings
expectations. Thus, when future earnings forecasts are revised, they reflect revisions of the
market’s future earnings expectations, and this causes share prices to change. Thus option 1) is
incorrect. In fact this finding is consistent with market efficiency not inefficiency. The fact that
share prices change when analysts revise their future earnings forecasts is consistent with
persistence of their forecasts, but only if analysts’ forecasts are viewed as the market’s earnings
expectations. Thus, option 3) is a better answer than option 2). It is true that revisions in earnings
forecasts might cause firms to change their operating policies, but that is not necessarily the
reason why they cause prices to change. Thus, again option 3) is a better answer than option 4).

b. 1) Topic 5.2 (Level 2)

The major reason why anomalies persist is that the costs of exploiting these anomalies for making
abnormal securities returns are prohibitively expensive. There are costs of making short sales,
brokerage costs, as well as costs of developing the necessary skills needed to evaluate firms’
financial reports. Only certain large financial institutions with the necessary skills and economies
of scale are known to have used some of these trading strategies. Thus, options 2) and 3) are
incorrect. Also, some research has revealed that the securities in which these anomalies are
concentrated tend to be small stocks and tend to trade infrequently. Thus option 4) is incorrect.

c. 2) Topic 5.7 (Level 1)

Value at risk is the estimated loss in earnings, cash flows, or fair values of firms that will happen
if the firm faces a large change in prices, which has a low, but nonetheless some, probability of
happening. This has nothing to do with employee stock options, so 1) is incorrect. The value at
risk concept is broader than those reflected in options 3) and 4), which are thus incorrect.

d. 3) Topic 3.2 (Level 1)

Beaver’s argument is that an efficient market is not fixated on financial statements and can
interpret information from any source and can make adjustments to financial statement numbers
when accounting policies are changed. This implies that accounting policies do not matter.
Option 2) contradicts Beaver because if accounting policies can signal they obviously matter.
Thus, option 2) is incorrect. Option 1) is not pertinent to the question and is incorrect. Option 4) is
another example indicating that accounting policy is relevant, and thus is contrary to Beaver
(1973) and is incorrect.

Continued...

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 e. 1) Topic 3.2 (Level 1)
Price protection refers to the fact that if security prices reflect publicly known information,
investors can trust securities markets to make their investment decisions. Option 2) is incorrect
because it is correct only under ideal conditions. Option 3) is incorrect because that is not what
price protection means. Option 4) is incorrect because in an efficient market, it is not possible to
identify which stock prices will rise and which will fall.

f. 4) Topic 8.3 (Level 1)

For growth firms, net income is relatively less sensitive to managerial effort than it is for other
firms. Thus managerial compensation is less based on net income for these firms and this
accounts for the low correlation between ROE and cash compensation for these firms. Thus,
option 3) is incorrect. Option 1) is incorrect because Lambert and Larcker (1987) found the
opposite result, namely that weight of ROE in compensation plans is high when correlation of
ROE and stock returns is low. Option 2) is incorrect because they did not examine the correlation
between ROE and beta risk.

g. 1) Topic 1.7 (Level 1)

Current valuation of assets and liabilities implies revenue recognition as soon as changes to
current value occur and is therefore early revenue recognition. This eliminates both option 2) and
option 4) as they state incorrectly that current value implies late revenue recognition. Cash flow
accounting recognizes revenue as cash is received and therefore implies late recognition. This
eliminates option 3). Historical cost revenue recognition falls in between these two extremes of
cash flow and current value.

h. 2) Topic 1.4 (Level 1)

In the present value model, accretion of discount arises because the stream of cash receipts is one
year closer at the end of the year than it was at the start of the year. Options 1) and 3) are incorrect
because net income is the interest on opening net assets. Therefore, using one plus the risk-free
rate gives the opening value plus the interest rather than just the interest. Additionally, option 3)
incorrectly uses the closing net assets value rather than the opening net assets value. Option 4) is
incorrect because the opening net assets value is divided by the risk-free rate instead of being
multiplied.

i. 3) Topic 1.7 (Level 1)

Reliable financial statement information faithfully represents without bias what it is intended to
represent and is verifiable. Option 1) is incorrect as relevance is not a dimension of reliable
financial statement information. Option 2) is incorrect as neither present value nor ideal
conditions are dimensions of reliability. Option 4) is incorrect because present value is not a
dimension of reliability.

j. 3) Topic 2.3 (Level 2)

The square root utility function is concave and therefore represents risk aversion across all values
of x ≥ 0. Therefore, options 1), 2), and 4) are all incorrect. Option 1) is true for a convex utility
function. Option 2) is true for a simple linear function. Option 3) would require a function that
starts being convex for small payoffs and transitions to concave for larger payoffs.

k. 4) Topic 2.1 (Level 1)

The theory of investment is an application of decision theory. Options 1), 2), and 3) are incorrect
because they associate it with other concepts in accounting theory.

Continued...

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 l. 1) Topic 2.4 (Level 2)
Foreign exchange rates, oil prices, and interest rates are all economy-wide factors that affect the
returns on shares of all firms. Option 1) is specific to the revenue-generating ability of a specific
firm.

m. 2) Topic 2.6 (Level 2)

Option 1) does not accurately describe beta because firm-specific risk is diversifiable and beta is a
measure of non-diversifiable risk. Option 3) is incorrect because beta is the covariance between
the firm’s returns and market returns and is not return volatility. Option 4) is incorrect because the
beta of the market portfolio is 1.0.

n. 2) Topic 3.1 (Level 1)

The form of efficiency described is semi-strong because share prices adjust to publicly available
new information very rapidly and in an unbiased fashion, such that no excess returns can be
earned by trading on that information. Option 1) is incorrect because in strong-form efficiency,
share prices reflect all information, public and private. Option 3) is incorrect and is not a standard
term in accounting theory. Option 4) is also incorrect as this ‘soft’ efficient securities market does
not require that prices remain at or near equilibrium, but only that market participants are not able
to systematically profit from market inefficiencies.

o. 2) Topic 10.3 (Level 2)

Principles-based accounting standards rely more on auditor professional judgment because there
are no detailed rules to be followed. Thus, option 1) is incorrect. Neither historical cost nor fair
value accounting are examples of either rules-based or principles-based accounting standards, as
such. That distinction is based on whether the standards lay down detailed rules on how to
account for transactions or not, either under historical cost or fair value accounting.

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15 Question 2
5 a. Source: Topic 4.3 (Level 1)
The earnings response coefficient (ERC) is the ratio of a security’s abnormal returns to the magnitude
of unexpected earnings of the firm.

ERC increases with earnings persistence for the following reasons. Note that security prices reflect
future expectations of cash flows to the firm. When earnings are persistent, for a given amount of
unexpected earnings (say, good news), future cash flows to the firm are expected to be higher. This
will cause share prices to change (increase). An increase in share prices will cause returns to increase,
and consequently abnormal returns to increase. ERC will increase because abnormal returns is the
numerator of ERC. If, on the other hand, the good news is not going to persist in the future, there is
little or no effect on future cash flows, and abnormal returns will not change or are less. Thus, ERC is
less.

5 b. Source: Topic 4.3 (Level 1)

Earnings persistence is higher when the firm achieves good news in earnings through a permanent
increase in market share. In such a situation, we expect the good news to continue. However, when
good news in earnings arises from an unanticipated gain on sale of assets, there is no guarantee that
this increase in earning (good news) will be achieved in future years too. Thus the earnings persistence
in this case is less.

5 c. Source: Topic 5.2 (Level 1)

Of the two components of earnings, accruals are more subject to estimation errors and possible
managerial biases, and thus the correlation of current period accruals and future income is less. That
is, earnings persistence is low if the good news in earnings is from increases in net accruals. Cash
flows from operations will have greater persistence because they are less likely to suffer from
estimation errors and/or managerial biases.

Another reason is that accruals reverse according to the iron law of accruals. For example, large
positive net accruals will eventually be reversed and if cash flows do not change, increases in earnings
due to increase in accruals are not sustainable and earnings persistence is less.

Note:
Either of these two reasons is worth full marks.

16 Question 3
6 a. Source: Topic 5.6 (Level 1)
Effect on net income ignoring taxes:
Cost savings = $2m
Savings in amortization charges = $2m ($20m/10 years)
Additional interest costs = 7% of $50m = $3.5m
Net effect on net income = $0.5m positive

10 b. Source: Topic 8.8 (Level 2)

(5) i) If the bonus plan has both a bogey and a cap, then the incentive depends on whether the net
income falls below the bogey, above the cap, or between the bogey and cap. If net income is
between the bogey and cap then managers have incentives to go ahead with the acquisition since
it will increase their bonuses. If net income falls above the cap or below the bogey, managers will
have incentives to reduce net income and will not proceed with the acquisition.

(5) ii) If the bonus plan has a bogey of zero and no cap, then it is in managers’ interest to increase net
income because it will increase their bonuses and they will go ahead with the acquisition.

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15 Question 4
5 a. Source: Topic 6.2 (Level 1)
The earnings announcement practice is an abuse of ESOs because it tries to unfairly influence the
exercise price of the ESO. The bad news announcement will lower the stock price, and since the
exercise price of ESOs is set at the stock price on the grant date, the exercise price will be lower. Note
that their managers do not report impending good news. If they did this, share prices would have
increased, thereby increasing the exercise price of ESOs. Note that the lower the exercise prices, the
higher the potential profit of managers in exercise of their ESOs. In other words, a lower exercise
price is beneficial to the ESO grant holders because the pay-off to ESO holders from the exercise of
ESOs and subsequent sale of such shares will be maximized.

10 b. Source: Topic 6.2 (Level 1)

(3) i) The reported ESO expense for 2003 is $0. The reported date of the ESO grant is July 15, 2003.
The exercise price of the ESOs is set to equal the stock price of $15 on that date. The intrinsic
value of the ESO is $0, which equals the ESO expense for the year.

(3) ii) The true ESO expense is $500,000. This is the restated amount. This is the amount shown in
ABC’s restated financial statements. The stock price on the true ESO grant date
(August 10, 2003) is $20 and the exercise price is $15. The intrinsic value of each ESO is $5
(20 – 15). Thus the true ESO expense is $5 × 100,000.

(4) iii) The practice of late timing is not consistent with GAAP, because under APB 25, which was in
effect when most of the late timing took place, firms had to report the actual intrinsic value as on
the date of award of the ESO grant (the “measurement date”). The intrinsic value on the ESO
grant date is the difference between the market price of the stock on that day (that is, $20) and the
exercise price ($15), or $5, and not zero. Late timing distorts expense recognition and violates
GAAP.

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14 Question 5
6 a. Source: Topic 7.3 (Level 1)
Let the percentage of net income be k.

Anushka’s expected utility must be at least 3 if she is to work hard, and equals:
EU (work) = 0.7 (0.8√576k + 0.2√196k.) + 0.3 (0.2√576k + 0.8√196k) – 7 = 3
= 0.56√576k + 0.14√196k + 0.06√576k + 0.24√196k – 7 = 3
= 0.62√576k + 0.38√196k – 7 = 3
= 20.2√k = 10
k = 0.2451

Anushka needs to be given 24.51% of net income for her to work hard.

4 b. Source: Topic 7.3 (Level 1)

With 24.51% of net income, if Anushka works hard, her expected utility is:
= 0.62√576k + 0.38√196k. – 7
= 0.62 × 24 × √k + 0.38 × 14√k – 7, where k = 0.2451 = 3

With 24.51% of net income, if Anushka shirks, her expected utility is:
= 0.3 (0.8√576k. + 0.2√196k) + 0.7 (0.2√576k + 0.8√196k) – 6
= 0.38√576k + 0.62√196k – 6
= 9.12√k + 8.68√k – 6, where k = 0.2451
= 8.811 – 6 = 2.811 < 3.00

Thus, if Anushka gets 24.51% of net income, she will work hard and not shirk.

4 c. Source: Topic 7.3 (Level 2)

If Anushka is allowed to manage earnings, she will always report $576 because she will get 24.51% of
this amount.

If she works, her expected utility is:

= 0.7 (0.8√576k + 0.2√576k + 0.3 (0.2√576k + 0.8√576k  – 7
= √576k – 7 (where k = 0.2451) = 4.88

If she shirks, her expected utility is:

= 0.3 (0.8√576k + 0.2√576k) + 0.7 (0.2√576k + 0.8√576k  – 6
= √576k – 6 (where k = 0.2451) = 5.88

Thus, Anushka will have incentive to shirk.

SAT1M10 ©CGA-Canada, 2010 Page 6 of 7

10 Question 6
6 a. Source: Topic 9.2 (Level 1)
(2) i) Credibility of information refers to the setting where the receiver of information knows that the
supplier of information has the incentive to disclose information truthfully.

(4) ii) Audits by the Big Four accounting firms are suggested to be more credible than audits by the
non-Big Four accounting firms because an audit failure will cost a Big Four accounting firms
more both in terms of loss of reputation and in terms of having greater wealth at risk from
litigation. Thus, Big Four accounting firms have a greater incentive to maintain high auditing
standards as compared to non-Big Four accounting firms. This will lead to greater credibility of
Big Four audits compared to non-Big Four audits.

Another reason why audits by Big Four accounting firms are credible is that they have more
diversified auditing experience than other firms. This makes it likely that they will be able to
maintain high auditing standards even for complex audit situations, as compared to non-Big Four
auditing firms.

Note:
Either of these two reasons is worth full marks.

4 b. Source: Topic 9.2 (Level 1)

When an owner-manager takes her firm public, her incentives to shirk and consume perks in the
post-IPO period will increase because she will bear less than 100% of the wealth loss that will accrue
from her excessive shirking/perks usage. The balance of the wealth loss will be borne by outside
shareholders. While she is 100% owner, the entire wealth loss from excessive shirking perks usage
would have been borne by her and by her alone. Outside investors will be aware of this incentive of
the owner-manager to increase shirking/perks consumption in the post-IPO period and will bid down
the price of the firm’s shares they are willing to pay, which will reduce the dollar amount the owner
manager would get from the IPO.

The owner-manager will rationally anticipate that outside shareholders will bid down share prices to
compensate for her increased shirking/perks consumption. She will then have incentives to contract to
take steps voluntarily that will potentially limit her shirking/perks consumption. One clause of the
contract might provide for an independent audit to ensure credibility of financial statements (she will
promise to produce) and ensure that perks consumption is within reasonable limits.

A 100% owner may also voluntarily submit to an independent audit before the IPO to signal that the
firm is “high-type.” It is not rational for a “low-type” owner-manager to choose to have an
independent audit performed and thereby incur audit fees to credibly reveal poor prospects.

Note:
Any of the two reasons explained above (contracting or signalling) is worth full marks.

END OF SOLUTIONS
100

SAT1M10 ©CGA-Canada, 2010 Page 7 of 7

 CGA-CANADA

ACCOUNTING THEORY & CONTEMPORARY ISSUES [AT1] EXAMINATION

March 2010
EXAMINER’S COMMENTS

General Comments
Most students did well on this examination. The multiple-choice questions were particularly well done
relative to previous examinations.

Some students are still not reading the questions carefully enough. A common shortcoming was to not pay
attention to action words, such as “explain.” Questions 2(a) and 4(a) were particularly subject to
incomplete explanations. When asked to explain, students should assume that they are explaining to
someone who is not very familiar with the question. Students should explain in their own words, using
course concepts, why their answer is correct.

Another result of not reading the question carefully is not giving a clear conclusion when one is needed.
Students should close their argument with a short summary statement. Question 3(a) was subject to this
problem for many students.

Several students did poorly on Question 5(a) (numerical agency theory question). There is at least one
numerical question on almost all examinations. Students should be able to answer questions on all the
numerical topics in the course (there are only a few). The best way for students to master numerical
questions is to practice them and check their answers. The assignment and review material provides ample
opportunity in this regard, as do the past examinations.

Specific Comments
Question 1 Multiple choice (Levels 1 and 2)
Performance on this question was satisfactory.

Performance on this question was much better than on previous examinations. Most students did quite
well.

Question 2 Earnings response coefficients and persistence (Level 1)

Performance on this question was satisfactory.

a. This part was reasonably well answered by most students. Some students did not realize that the ERC
definition is abnormal share return divided by unexpected earnings. Also, many explanations of why
ERCs and persistence are related did not go deep enough. Students should think of the decision process of
a rational investor: more persistence → increased expectations of future cash flows → higher probability
of good future firm performance → buy decisions → increased share price → higher ERC. Students must
be sure to explain when asked.

b. This part was well answered by most students.

c. This part was well answered by most students. Some students felt that persistence of accruals was greater.
This is contrary to the well-known anomaly study of Sloan (1996). However, if it was argued that accruals
could be used to smooth earnings and (by definition) smoothed earnings persist, part marks were awarded.

Continued...

AT1M10 ©CGA-Canada, 2010

 Question 3 Mini case on earnings management for manager bonus purposes (Levels 1 and 2)
Performance on this question was satisfactory

a. This part was correctly answered by many students. Many others, however, did not notice that only
the effect on net income in the first year was asked for. Not noticing this produced a variety of
incorrect answers, many of which included complex and time-consuming discounting. Also, a few
students did not give a conclusion to their answer. Students needed to indicate whether the manager
would undertake the acquisition or not.

b. This part was well answered by most students.

Question 4 Executive stock options, manager abuses thereof (Level 1)

Performance on this question was satisfactory.

a. This part was reasonably well answered by most students. However, while many students correctly
explained how the release of bad news just before award date increased expected profit of managers,
relatively few explained how failing to announce good news had a similar effect. Both effects should
have been explained, since the question mentioned both.

b. Many students were not aware of the accounting for executive stock options under APB 25, even
though the wording of the question gave some information in this regard.

Question 5 Agency theory problem (Levels 1 and 2)

Performance on this question was satisfactory (borderline).

a. Some students did not set up the equation correctly. Some of those that did seemed uncomfortable
working with square roots. A few students worked with cash flows, not net income. This is incorrect
in this question because the contract is single-period. That is, the question states that the manager can
be paid a fraction of net income, which is known at the end of the first year, and that the manager
wants compensation at the end of the first year. Cash flows are not known until the second year.

b. Part, or even full, marks were awarded for part (b) if the answer correctly followed from the student’s
answer to part (a). However, many students did not calculate the manager’s expected utility if she
shirked. If the manager is to work hard, the expected utility of working hard must be equal or greater
than that from shirking.

c. Answers that correctly explained that despite the contract in part (a) motivating the manager to work
hard, the rational manager would shirk after being hired if there was a way for her to work out from
under working hard. Managing net income provides such a way. Superior answers would calculate the
manager’s expected utility from shirking and managing earnings and verify that this is greater than the
expected utility from working hard as per part (a). However, this was not required for full marks.

Question 6 Role of auditors in providing credible earnings numbers (Level 1)

Performance on this question was satisfactory.

a. Numerous students missed the essence of credibility, namely that the recipient of the information
knows that the supplier of information has an incentive to report truthfully.

Numerous students also did not realize that the essence of increased credibility of a large audit firm is
that the large firm has more to lose. This loss can be in terms of deep pockets, higher litigation
awards, and/or loss of reputation.

Continued...

AT1M10 ©CGA-Canada, 2010

 b. Few students pointed out explicitly that the owner-manager has in increased incentive to shirk relative
to 100% ownership prior to going public. This is because before the public offering the owner bore all
of costs of shirking, whereas after he or she bears only part of the costs.

An equivalent answer is that after the public offering, the new owners bear agency costs (this is really
just another way of saying that the manager has an increased incentive to shirk). However, the
question asked students to discuss why the owner would be willing to commit to an audit. This
requires consideration of the pros and cons of an audit as a way to control agency costs. The benefits
are that the owner will receive a higher price for his or her initial public offering. The costs are the
constraints on the manager’s ability to take perquisites, and the cost of the audit. Few students gave a
complete discussion.

AT1M10 ©CGA-Canada, 2010