Chapter 4 - Solution Manual

We can use these objectives and assumptions to

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certainly be relied upon to aid in the development of logical and consistent accounting standards. We can use these objectives and assumptions to logically derive accounting standards using a deductive
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74 approach. In other words, deduction, based on agreed upon assumptions, is an appropriate approach to accounting theory development. This is the normative approach. WWW Case 4-9 a. Agency relationships involve costs to principals. Agency costs have been defined as the sum of (1) monitoring expenditures incurred by principals to control the behavior of agents, (2) bonding expenditures incurred by the agent, and (3) the residual loss. Monitoring expenditures include such costs as costs of measuring and observing the agent’s behavior and the costs of establishing compensation schemes that would tend to provide incentives to the agent to realign personal goals to be closer to those of principals. Bonding expenditures are incurred by the agent to guarantee that he will not take certain actions to harm principal’s interest or that he will compensate the principal if he does. The wealth effect caused by a difference between actions taken by the agent and what the principal would have the agent take. Because individuals are expected to take actions to maximize their own utility, managers and shareholders are expected to incur monitoring and bonding costs as long as these costs are less than the residual loss. b. An increase in debt would increase agency costs. An increase in debt would increase interest expense and lower income to stockholders. It would also increase the debt-to-equity ratio and thus would be perceived as increasing risk. Increase in risk may increase the cost of debt via increased interest rate. c. To reduce risk, debt-holders often restrict the amount of debt a company can issue, by putting a limit on the company’s debt-to-equity ratio. The debt covenants are a bonding cost that reduce the cost of debt. Case 4-10 The students will have different answers to this case depending on the companies selected and the time period chosen. Financial Analysis Case The students will have different answers to this case depending on the companies selected. CHAPTER 5 Case 5-1 a. Earnings management is the attempt by corporate officers to influence short-term reported income. It is believed that managers may attempt to manage earnings because they believe investors are influenced by reported earnings. The methods of earnings management include the use of production and investment decisions, and the strategic choice of accounting techniques
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