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Accounting Theory

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These questions are from the Text Book – Scott, W.R., Financial Accounting Theory – 5th Edition, Person Prentice-Hall, 2009. ISBN: 978-0-13-207286-1.
Question 1: From Chapter 4 (Efficient Securities Markets) Question 13.
Zhang (2005) examined revenue recognition practices in the software industry. Software firms derive revenue from software licensing and post-contract customer support. In both cases, the point in time when significant risks and rewards of ownership are transferred to the buyer and amounts to be receive can be reliably measured are unclear. Consequently, there is scope for alternative revenue recognition practices in the industry.
With respect to licensing, one alternative is to recognize revenue when the licensing contract is signed (early recognition). Another is to wait until the software is delivered to the customer, consistent with the usual sales basis of revenue recognition (late recognition). With respect to post-contract customer support, alternatives are to recognize revenue when contracts are signed (early recognition) or recognize revenue ratably over the term of the contract (late recognition).
Zhong examines a sample of 122 firms over 1987 – 1997, of which 22 firms were early recognizers and 93 late. He measured the relevance of a firms’s quarterly revenue by its association with its share returns for the quarter. Given the securities market efficiency, revenues of early recognizers should be more highly associated with their share returns than revenues of late recognizers. Zhang reported significant statistical evidence consistent with this expectation.
Zhang measured the reliability of revenue information by examining the cash flows from quarter-end accounts receivable collected over the following two quarters. Recall that in Section 3.8 we pointed out the role of accruals in anticipating future cash flows. Thus, the closer are the amounts of cash collections over these following two quarters to opening net accounts receivable, the more reliable the revenue information. Zhang found that the reliability of the revenue information measured this way was significantly less for early recognizers than for late recognizers.
Combination of these two findings suggests that relevance and reliability must be traded off, since the greater relevance of early revenue recognition is accompanied by reduced reliability.
Required:
a) Explain why securities market efficiency implies that revenues of early recognizers should be more highly associated with their share returns than revenues of late recognizers. In your answer, assume that information about licensing contracts becomes public information when the contract is signed. b) Explain why the closer are cash collections for the following two quarters to opening accounts receivable, the more reliable is revenue information. c) Do Zhang’s findings imply that early revenue recognition for licensing contracts has the potential to be decision useful for investors? Use the concept of an information system (in particular, the effects of relevance and reliability on the main diagonal probabilities) your answer.
(30 marks – 10 each)

Question 2: From Chapter 5 (The Information Perspective on Decision Usefulness) Question 18.
On October 19, 2000, The Globe and Mail reported on Imperial Oil Ltd’s earning for the third quarter ended on September 30, 2000 released on October 18. Net income was a record #374 million, up from $191 million for the same quarter of the previous year. Return on equity was 25.7%, up from 10.0% a year earlier. Earnings for the quarter included a $60 million gain on Imperial’s sales of its Cynthia pipeline and other assets. Cash flow for the quarter was $433 million, up from $270 million in the previous year’s third quarter. The reported profit of $374 million was in line with analysts’ expectations.
On October 18, the TSE oil and gas index rose by 0.6%, as the market anticipated higher prices for oil and gas. Yet, Imperial’s share price fell on the day by $1.25, to close at $37.35. The Globe and Mail also reported analysts’ comments about a widening discount for heavy crude oil, relative to light crude. Imperial is Canada’s biggest producer of heavy crude. Also, Imperial’s production from its old sands projects declined in the quarter, due to maintenance and temporary production problems.
Required:
a) Use the market model to calculate the abnormal return, relative to the TSE oil and gas index, on Imperial Oil’s shares for October 18, 2000. Imperial Oil’s beta is approximately 0.65. The risk-free interest rate at this time was approximately 0.0002 per day. Note the theoretical relationship a = R (1 – B).
J f j b) Is the abnormal decline in Imperial’s share price on October 18 consistent with efficient securities market theory? Explain why or why not. Consider earnings persistence in your answer. c) In what section of the income statement should the $60 million gain on the sale of the Cynthia pipeline be reported? Explain.
(30 marks)
Question 3: From Chapter 8 (Economic Consequences and Positive Accounting Theory) Question 14.
Recent years saw a significant increase in “covenant-lite”debt, under which debt contracts had few if any debts covenants. For example, a private equity firm may issue such debt to finance a planned takeover. One estimate is that, in 2007, covenant-lite debt accounted for 35% of all debt issued in the United States.
This debt typically bought by financial institutions, such as banks. A bank may then combine this loan with other similar loans and slice the total up into tranches, that is, into packages of debt of similar credit quality, called asset-backed securities or collateralized debt obligations (CDO). It will then sell these tranches to investors on a secondary loan market. The purchaser will receive his/her share of the interest and principal payments paid by the firms whose debt is in that tranche. Thus, the investor can buy interest-bearing debt with the level of default risk he/she desires, and pay accordingly. The effect is to disperse credit risk through the economy. It is expected that even for tranche of low quality there will be no more than a few defaulting firms, so that any credit losses are spread over all the investors in that tranche.
Furthermore, it is possible to increase the credit quality of a CDO by buying credit default swaps (CDS). These are derivative instruments under which the issuer of the CDS, for a fee, agrees to compensate tranche investors for credit losses incurred by that tranche. If CDSs are brought to protect, say, 25% of the underlying debt in the tranche, the effect is to increase the credit quality of the tranche significantly. This further disperses credit risk, since now at least part of the risk is borne by the CDS issuers.
Required:
a) If you were an investor in interest-bearing securities, would you be willing to invest a substantial amount of your capital in tranches secured by covenant-lite debt? Explain your reasons. b) Concerns are sometimes expressed that issuing covenant-lite debt creates a moral hazard problem. What is the problem? c) What would be the effect of covenant-lite debt on the validity of the debt covenant hypothesis of PAT? d) The ability to increase the credit quality of high-risk debt by means of CDSs seems almost ‘magical’. From the standpoint of a CDO investor, do you see a downside to investing in CDOs, particularly if protected by CDSs? Explain.
(30 marks)

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