Quiz 1
Question 1
0.4 out of 0.4 points
Firm performance can be measured in a variety of ways. Which of the following measures of firm performance is most useful to
investors, according to the FASB conceptual framework?
Selected Answer:
1. Net income based on accrual accounting.
Correct Answer:
1. Net income based on accrual accounting.
Feedback: You are correct! This is the position of SFAC 1, on grounds that accrual-based accounting smoothes out the
“lumpiness” of cash flows. Furthermore, the ability of current net income to better predict future cash flows than
current cash flows themselves is supported by the empirical results of Kim and Kross (2006). Thus answer 2 is
incorrect.
Answer 3 is incorrect because of severe problems of reliability if net income were to be prepared on a present
value basis.
Answer 4 is incorrect because while dividends are a primary interest of investors according to SFAC 1, SFAC 1
does not claim that dividends paid are the most useful measure of firm performance. (Topic 2.7)
Question
0.4 out of 0.4 points
2
The concept of relevant information is important in financial accounting theory, and is a key component of decision usefulness.
Which of the following statements best captures the concept of relevance?
Selected Answer:
2. Relevant information provides investors with information about the firm’s future performance.
Correct Answer:
2. Relevant information provides investors with information about the firm’s future performance.
Feedback: You are correct! Providing information about future performance is the essence of relevance.
Answer 1 refers to reliability, not relevance.
Answer 3 is too strong. Historical cost provides some relevance, but “very relevant” is not correct.
Answer 4 is incorrect because relevance has to be traded off against reliability. It does not increase reliability.
(Topic 1.7)
Question 3
0.4 out of 0.4 points
Accretion of discount is a term commonly used in present value accounting, including reserve recognition accounting. Which
of the following expressions best describes accretion of discount?
Selected Answer:
3. Accretion of discount measures expected net income.
Correct Answer:
3. Accretion of discount measures expected net income.
Feedback: You are correct! This is the definition of accretion of discount. In present value accounting, expected net income
is calculated as opening net asset value times the interest rate, much like the expected earnings from a bank
savings account equals the opening balance times the interest rate paid on deposits. The term gets its name
because future expected cash receipts are closer (i.e., they accrete) at the end of the period than at the first of the
period.
Answer 1 is correct under ideal conditions of certainty, but not under uncertainty since actual net income differs
from expected net income depending on the state realization.
Answer 2 is incorrect. Actual cash flows and accretion of discount will not be equal under ideal conditions of
uncertainty when expected and actual cashflows are not equal.
Answer 4 is incorrect because the standardized measure changes for reasons in addition to accretion of discount,
such as new discoveries, changes in prices and costs, etc. (Topic 1.4)
Question 4
0 out of 0.4 points
Gaa and Smith (ERH, Unit C4) consider the pressures on accountants and auditors to go along with deceptive financial
reporting. According to Gaa and Smith, which is the most convincing reason why accountants and auditors should resist such
pressures?
Selected Answer:
2. Deceptive financial reporting is unlikely to ensure the firm’s long-term survival.
Correct Answer:
3. Deceptive financial reporting does not take into account its impact on investors and lenders.
Feedback: Incorrect. This is Gaa and Smith’s argument, based on the position of the deceived. Argument 1 is less persuasive
than argument 3 since some deceptions may never be discovered or, if they are, they may not be a result of
accrual reversal. For example, classifying a non-current asset or liability as current does not involve accruals, but
could be deceiving under some circumstances.
Answers 2 and 4 may be correct statements, but are not arguments made by Gaa and Smith. (Topic 2.8)
Question 5
0.4 out of 0.4 points
Under ideal conditions, accounting is based on present values or expected present values of assets and liabilities. When conditions
are not ideal, present value accounting encounters severe problems of implementation. Which of the following statements
represents the most severe implementation problem?
Selected Answer:
2. Reliable estimates of future cash flows may not be possible.
Correct Answer:
2. Reliable estimates of future cash flows may not be possible.
Feedback: You are correct! The difficulty of preparing reliable estimates of future cash flows can be seen in reserve
recognition accounting (RRA). Despite several features of RRA standards intended to increase reliability, major
changes to previous estimates are usually needed. While market values provide an alternate way to estimate
present values (due to arbitrage), markets do not exist for all assets and liabilities (incomplete markets).
Answer 1 is a relatively less severe problem, since a proxy for a risk free interest is available (e.g., interest rate on
government bonds), firms can estimate their costs of capital, and accounting standards can prescribe interest rates
(e.g., SFAS 69 and CSA NI 51-101).
Answer 3 is incorrect because probabilities of states of nature are subjective; they have to be assessed by the
decision maker based on all of his/her prior information.
Answer 4 is incorrect because calculation of present values under uncertainty is used when cash flows are risky.
This can be done by identifying relevant states of nature and assessing subjective probabilities of these states.
(Topics 1.6 and 2.2)
Quiz 2
Question 1
0 out of 0.4 points
Regulation FD was implemented in the United States in 2000. Similar regulations exist in Canada. What is the purpose of
Regulation FD?
Selected
Answer:
Correct Answer:
1. To prevent insider trading
2. To improve the operation of securities markets by reassuring investors that the market is a level
playing field
Feedback: Incorrect. Regulation FD prevents firms from releasing information to analysts before releasing it publicly. This
reduces investor concern that analysts may use this information for their or their clients’ own benefit before
incorporating it into their forecasts.
Answers 1 and 3 are incorrect because Regulation FD does not require the release of inside information. Thus,
insider trading and the lemons problems remain.
Answer 4 is incorrect because Regulation FD may speed up the public release of information, but nothing
requires that the information released be more relevant and reliable than information released prior to regulation
FD. Also, relevance and reliability are unlikely to be both increased, since these two information characteristics
must be traded off. (Topic 3.6)
Question 2
0.4 out of 0.4 points
A firm’s earnings response coefficient (ERC) has increased from 2.1 last year to 2.6 this year. Which of the following reasons
is most likely to be the cause of the increase?
Selected Answer:
2. The firm’s ratio of inventory to sales decreased for the year.
Correct Answer:
2. The firm’s ratio of inventory to sales decreased for the year.
Feedback: You are correct! According to the results of Lev & Thiagarajan (1993) (Text, 5th edition, page 167), a decrease
in the ratio of inventory to sales suggests increased earnings quality, due to greater efficiency in managing
inventories. An increase in earnings quality increases the ERC. The other reasons all suggest a decrease in the
ERC. (Topic 4.3)
Question 3
0.4 out of 0.4 points
Accounting researchers have documented a decline in the earnings response coefficients (ERC) of firms that report large and
numerous unusual and non-recurring items, particularly if such items appear frequently over time. Why would the ERC decline
for such firms?
Selected Answer:
1. The market interprets such behaviour as putting earnings in the bank.
Correct Answer:
1. The market interprets such behaviour as putting earnings in the bank.
Feedback: You are correct! This was the finding of Elliott & Hanna (1996). They attributed lower ERCs as due to the
market’s interpreting frequent recording of unusual and non-recurring items as evidence of their potential misuse
by management. For example, management may overstate unusual and non-recurring losses so as to put future
earnings in the bank, to be drawn down as needed to avoid reporting lower future earnings.
Answer 2 is incorrect because unusual and non-recurring items can be gains as well as losses.
Answer 3 is incorrect because classificatory smoothing was effectively eliminated by changes to accounting
standards to add “…do not depend primarily on decisions or determinations by managers…” to the definition of
an extraordinary item. Therefore, it is unlikely that such smoothing underlies the market’s reaction.
Answer 4 is incorrect because in theory a low beta should raise the ERC, a prediction supported by the empirical
evidence of Kothari (1989) and Easton & Zmijewski (1989). (Topic 4.4)
Question 4
0.4 out of 0.4 points
To retain accountants’ competitive advantage as suppliers of information, it is essential that earnings reports be of high quality.
Which of the following statements best characterizes earnings quality?
Selected Answer:
1. Accruals accurately predict future cash flows.
Correct Answer:
1. Accruals accurately predict future cash flows.
Feedback: You are correct! This is the approach to earnings quality of DeChow & Dichev (2002). They argue that earnings
quality is primarily determined by accruals quality, since operating cash flows (recall that earnings = operating
cashflows plus net accruals) are relatively free of problems of error and bias. These researchers measure accruals
quality by the correspondence between current-period accruals and next period’s cash flows. Since cash flows are
the ultimate interest of investors, higher correspondence means that accruals, hence earnings, better predict future
firm performance. Empirical evidence supports DeChow & Dichev’s argument, in that share price responds
positively to earnings quality measured according to this procedure.
Answers 2 and 3 are backwards. Higher off-main diagonal probabilities and lower persistence both reduce
earnings quality.
Answer 4 is incorrect because, while little debt increases the ERC, this does not in itself imply low earnings
quality. Earnings can still do a good job in predicting future firm performance in the presence of low debt. (Topic
4.3)
Question 5
0.4 out of 0.4 points
Accounting information has characteristics of a public good. Why?
Selected Answer:
3. The same accounting information can be reused by others.
Correct Answer:
3. The same accounting information can be reused by others.
Feedback: You are correct! This is the definition of the public good characteristic of accounting information, which makes it
difficult for firms to charge users for their information.
Answers 1 and 4 are incorrect because accounting information helps users make investment decisions and
improves market operation regardless of whether this information is a public good. Answer 2 is a correct
statement, but is not a criterion for a public good. Rather, public bodies regulate accounting standards because
accounting information is a public good. (Topic 4.5)
Quiz 3
Question 1
0.4 out of 0.4 points
Accountants continue to debate why the efficient securities market anomalies of post-announcement drift and accruals anomaly
continue to exist, even several years after being first identified. Which of the following statements is the most likely
explanation?
Selected Answer:
4. There are limits to arbitrage (i.e., cost and risk).
Correct Answer:
4. There are limits to arbitrage (i.e., cost and risk).
Feedback: You are correct! It seems that limits to arbitrage, specifically transactions costs and idiosyncratic risk, are the most
likely explanation why the anomalies are not arbitraged away. The transactions costs of exploiting the anomalies,
including costs of short selling and investor time, in addition to brokerage commissions, are quite high. Also,
investing to exploit the anomalies is more risky than a strategy of diversified investment. It may be that the excess
returns documented by the post-announcement drift and accruals anomaly researchers represent a return to bearing
this risk rather than an anomalous return due to market efficiency.
Answer 1 is too strong because there is considerable evidence (see Module 4) that securities markets are quite
efficient. The text concludes that markets are close enough to efficiency that we can accept its implications for
accounting. If so, limits to arbitrage provide better reasons why the so-called anomalies continue despite market
efficiency.
Answer 2 is incorrect because if investors learned about the anomalies over time, and if there were no limits to
arbitrage, they would increasingly exploit the anomalies to earn arbitrage profits. Then, the anomalies would not
persist.
Answer 3 is incorrect because there is evidence that sophisticated institutional investors do earn profit by
exploiting the anomalies. However, the amount of profit they earn is quite small and not sufficient to eliminate the
anomalies. (Topic 5.2)
Question 2
0.4 out of 0.4 points
The Ohlson/Feltham clean surplus model has had considerable impact on accounting theory and practice. Which of the
following statements about this model is of greatest significance to accountants?
Selected Answer:
4. The clean surplus model provides a practical way to estimate firm value.
Correct Answer:
4. The clean surplus model provides a practical way to estimate firm value.
Feedback: You are correct! By adding an estimate of unrecorded goodwill based on abnormal earnings to the balance sheet
value of shareholders’ equity, the clean surplus model provides a practical way to estimate firm value based on
accounting information.
Answer 1 is incorrect because, while goodwill estimates can be made, their reliability can be questioned.
Answer 2 is incorrect because clean surplus theory assumes that all items of gain and loss to go through the
income statement (hence its name).
Answer 3 is too strong. While the model can handle full fair value accounting, it produces the same firm value if
the firm uses a mixed measurement model. Different measurement bases on the balance sheet are compensated
for by different amounts of estimated goodwill. (Topic 5.3)
Question 3
0.4 out of 0.4 points
Accounting standard setters have been moving towards fair value accounting for some time. Which of the following statements
is the most important reason for this trend?
Selected
Answer:
2. Auditor legal liability may result when failing firms take advantage of historical cost accounting to
disguise financial distress.
Correct
Answer:
2. Auditor legal liability may result when failing firms take advantage of historical cost accounting to
disguise financial distress.
Feedback: You are correct! Disguising of financial distress was a feature of the Savings and Loan debacle in the United
States during the 1980s. Many audit firms were found liable for issuing unqualified financial statements for
institutions that were effectively insolvent. Fair value accounting, it is argued, makes it more difficult to disguise
insolvency, thereby reducing auditor liability.
Answer 1 is incorrect because fair value information will not be more decision useful than historical cost if its
greater relevance is outweighed by lower reliability.
Answer 3 is incorrect because the efficient market will find fair value information just as useful whether it is in
the financial statement notes or in the financial statements proper.
Answer 4 is incorrect because while standard setters would likely prefer fair value accounting for intangibles, the
low reliability of fair value accounting for intangibles such as research has prevented significant progress. (Topic
5.2)
Question 4
0.4 out of 0.4 points
The fair value option of IAS 39 and SFAS 159 allows firms to fair value an asset or liability even if not required to do so by
GAAP. Which of the following statements represents the most appropriate use of the fair value option?
Selected Answer:
1. To reduce earnings volatility.
Correct Answer:
1. To reduce earnings volatility.
Feedback: You are correct! Firms frequently enter into natural or derivative hedges of assets and/or liabilities. When an
asset or liability is valued at fair value with related unrealized gains and losses included in net income, earnings
volatility will be greater than the firm’s actual volatility if the other side of the hedge is not fair valued. For
example, a firm might hedge the risk of changing interest rates on the value of its long-term debt by acquiring
interest-bearing financial instruments. If the fair value of the financial instruments changes, but the debt is
recorded at cost (the usual basis of valuation for long-term debt), the volatility of reported earnings will exceed
the firm’s real volatility. The fair value option gives the firm the option of reducing this volatility by fair valuing
the debt. Indeed, IAS 39 restricts the use of the fair value option to mismatches such as this.
Answers 2 and 3 are too vague to be correct answers, For example, a firm may use the fair value option under
U.S. GAAP (which does not restrict the fair value option to reduction of mismatches) to increase or decrease net
income, for example, to meet earnings expectations such as analysts’ forecasts. This is hardly appropriate.
Answer 4 is incorrect for a similar reason. If the firm uses the fair value option to fair value its debt, this could be
appropriate if a mismatch is reduced. However, if this is not the case, use of the fair value option may not be
appropriate. Thus, answer 1 dominates answer 4. (Topic 5.5)
Question 5
0.4 out of 0.4 points
IAS 39, and similar standards in Canada and the United States, require that many financial instruments, including most
derivatives, be accounted for at fair value. However, fair value accounting can produce considerable volatility in net income,
particularly if there is a mismatch. Which of the following provisions are used by these standards to reduce net income
volatility?
Selected
Answer:
2. Unrealized gains and losses on some financial instruments are included in other comprehensive
income.
Correct Answer:
2. Unrealized gains and losses on some financial instruments are included in other comprehensive
income.
Feedback: You are correct! By including unrealized gains and losses on available-for-sale financial assets and cash flow
hedges in other comprehensive income, the volatility of net income is reduced.
Answer 1 is incorrect because deferral of such items is no longer allowed under GAAP, since such deferrals are
inconsistent with a measurement approach.
Answer 3 is incorrect because application of an impairment test increases, not decreases, net income volatility.
Answer 4 is incorrect because there is no particular reason to expect that unrealized gains and losses on trading
securities will offset in the period. As a result, including them in net income will increase, not decrease,
volatility. (Topic 5.5)
Quiz 4
Question 1
0.4 out of 0.4 points
Theory suggests that, under fairly general conditions, more than one performance measure increases compensation contract
efficiency (Holmstrom (1989). As a result, we expect to observe (and in fact do observe) manager compensation based on both
net income and share price performance. Then, the proportion of total compensation based on net income is of interest to
accountants. Under which of the following conditions will the proportion of compensation based on net income be the highest?
Selected Answer:
4. When the firm wants the manager’s decision horizon to be relatively short.
Correct Answer:
4. When the firm wants the manager’s decision horizon to be relatively short.
Feedback: You are correct! Net income-based compensation encourages a short-run manager decision horizon since short-run
decision (e.g., cost-control, sales drives and advertising campaigns) show up largely in current period’s net
income, upon which the manager’s compensation is based. Longer-term decisions (e.g., R & D) are subject to
recognition lag.
Answer 1 is incorrect because the net income of rapidly growing firms is particularly subject to recognition lag,
thereby favouring share-based compensation.
Answer 2 is irrelevant to the question asked, since it is a motivation for earnings management, not for a short term
decision horizon.
Answer 3 is possibly correct, but is inferior to 4. Precision of a performance measure per se encourages its
influence in compensation, but this influence is reduced if the performance measure is low in sensitivity.
Consequently, it is unclear if precision of net income by itself encourages a high proportion of net income-based
compensation. (Topic 8.3)
Question 2
0.4 out of 0.4 points
Why can earnings management be “good”?
Selected Answer:
1. Violation of debt covenants is costly.
Correct Answer:
1. Violation of debt covenants is costly.
Feedback: You are correct! If the manager manages earnings to work around the effects of an unanticipated change in GAAP,
this may be a low-cost way to protect the firm and the creditors from technical violation, consistent with the
efficient contracting version of positive accounting theory. This is an example of good earnings management.
Answer 2 is incorrect because unusual and non-recurring items are frequently used to manage earnings, as for
example in the case of General Electric Company (good), or the tactics described by Hanna (bad).
Answer 3 is incorrect because managing earnings to attain reservation utility represents bad earnings management.
For example, the manager may shirk (thereby raising utility) and cover up by managing earnings upwards.
Answer 4 is incorrect because the flexibility allowed by GAAP enables earnings management that can be bad as
well as good. While GAAP constrains earnings management, it does not eliminate it. (Topic 8.7)
Question 3
0 out of 0.4 points
In agency theory, under which of the following conditions can the first-best manager compensation contract be attained?
Selected Answer:
3. The payoff from manager effort is completely observable at the end of the contract period.
Correct Answer:
4. The agent’s act can be at no cost observed by the principal.
Feedback: Incorrect. When the agent’s act can be observed, the compensation contract can be based on whether or not the
manager takes the act (e.g., working hard) desired by the principal. Such a contract would pay the manager a
salary, thereby imposing no risk if the desired act is taken. Since managers are assumed to be risk averse, and
thus trade off risk and return, a salary enables the manager to attain reservation utility with the lowest possible
amount of compensation to the manager. This maximizes the expected payoff to the principal. Such a contract is
called first best.
Answer 1 is incorrect because, according to Danielson (ERH B3), straightforward maximization results in a Nash
equilibrium that is inferior to the cooperative equilibrium. The cooperative equilibrium can be attained under
constrained maximization. Anyway, the Danielson analysis applies to a non-cooperative game whereas agency
theory has characteristics of a cooperative game. Thus, Danielson’s argument does not apply to agency theory.
Answer 2 is incorrect because the principal is always assumed to maximize utility. If the agent’s effort cannot be
observed, directly or indirectly, the principal still designs a contract to maximize expected utility, although this
maximum falls short of that achieved under first best.
Answer 3 is incorrect because if the payoff can be observed at period-end, the agent’s contract can be based on
the payoff, rather than on a performance measure such as net income. But this does not imply that the contract is
first best — this depends on whether or not the agent’s effort is observable. (Topic 7.3)
Question 4
0.4 out of 0.4 points
Due to the unobservability of manager effort and resulting moral hazard problem, compensation contracts are usually based on
manager performance. If so, which of the following measures of manager performance will generate the most efficient (i.e.,
lowest agency cost) compensation contract?
Selected Answer:
4. Both share price performance and core earnings.
Correct Answer:
4. Both share price performance and core earnings.
Feedback: You are correct! According to the analysis of Holmström (1979), basing compensation on more than one
performance measure increases contract efficiency under quite general conditions. Also, core earnings is less
affected than net income by unusual and non-recurring items, which may be of low persistence and relatively
uninformative about manager effort.
Answer 1 is incorrect, even though the payoff is the best measure of effort. Due to recognition lag, the payoff is
unlikely to be observable until after the manager’s current-period compensation contract has expired.
Answers 2 and 3 are incorrect in view of Holmström’s analysis. (Topic 7.4)
Question 5
0.4 out of 0.4 points
In many managerial compensation contracts, a greater proportion of total compensation is based on share price performance
rather than on net income. Which of the following statements is the most likely reason?
Selected Answer:
2. Compensation committees wish to motivate a long run manager decision horizon.
Correct Answer:
2. Compensation committees wish to motivate a long run manager decision horizon.
Feedback: You are correct! Since net income lags in recognizing many components of current manager effort (e.g., R & D),
share price is more sensitive to long run effort than net income. Then, compensation based on share price
performance motivates a long run decision horizon. While it is correct that net income is less sensitive than share
price performance, it is also more precise. Thus, it is not clear that low net income sensitivity motivates more
share price-based compensation than net income. Thus, answer 1 is incorrect. Answer 3 is backwards.
Answer 4 is incorrect because this was not Holmstrom’s result. He demonstrated that under quite general
conditions, two performance measures create a more efficient compensation contract than one. This implies that
net income and share price compete for influence over manager compensation, but not that the proportion of
share price-based compensation should necessarily be high. (Topic 8.3)