Suggested Solutions to Assigned Problems in Chapter 4: 1, 2, 3, 8, 12
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.
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