Chapter 4_Solutions

Chapter 4_Solutions - Suggested Solutions to Assigned...

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Suggested Solutions to Assigned Problems in Chapter 4: 1, 2, 3, 8, 12 1. The differing market response could be explained by a difference in the market’s expectations of earnings. The net income of the firm that had the strong reaction may have been higher than expectations, whereas the net income of the other firm may have been equal to or less than expectations. Another reason could be a difference in the quality of earnings. The firms may have used different accounting policies. For example, one firm may have used declining-balance amortization and successful-efforts accounting, whereas the other may have used straight-line and full-cost methods. If the accounting policies of one firm are more relevant and/or reliable than those of the other, the main diagonal probabilities of its information system would be higher, inducing a stronger market response. Finally, the informativeness of price could have differed between the two firms, although this is less likely when the firms are the same size. However, the firm whose share price changed only slightly may have released more information during the year, say by quarterly reports, forecasts, or manager speeches, and the efficient market would build this information into the share price prior to the earnings announcement. 2. share per income Net share per value Market ratio earnings to Price = During a period of rising prices, we would expect a LIFO firm to report lower net income than a FIFO firm, other things equal. Also, unless a firm is contracting, or has very old capital assets, we would expect a firm that uses declining-balance amortization to report lower net income than if it used straight-line. Thus, even though their reported net incomes are the same, a dollar of current net income suggests higher expected future payoffs for Firm A than Firm B. Since investors value higher future payoffs and the Page  1  of  5
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higher share returns these imply, Firm A should sell at a higher price-to-earnings ratio than Firm B, all other things equal. The above follows from efficient markets theory. The market is not fooled by the same reported net incomes for Firm A and firm B. Rather, it perceives the impact of accounting policy choice on current earnings and the implications of such choice for earnings quality and future payoffs. If the market did not look through reported earnings this way, we would expect that Firm A shares would trade at the same price as Firm B’s because the
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This note was uploaded on 12/14/2010 for the course ACC 706 taught by Professor Shadifarshad during the Winter '09 term at Ryerson.

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Chapter 4_Solutions - Suggested Solutions to Assigned...

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