4-2
Price to earnings ratio  Market value per share/Net value per share
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, for a rapidly growing firm, we would expect it 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 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 market would then react naively to the bottom line. Note: This answer assumes that the use of LIFO inventory has no cash flow effects. If firms A and B were in a jurisdiction that allows LIFO for tax purposes and firm A took advantage of this provision while firm B did not, firm A’s cash flows would be higher than firm B’s, at least during a period of rising prices. This would further increase A’s price-to-earnings ratio relative to firm B. This answer also assumes that both firms use the same depreciation method for tax purposes. This seems reasonable since most jurisdictions, such as Canada, impose their own tax depreciation regulations.
4-4
The financial press should provide a relevant source of information for investors. The information provided by the financial press is not subject to the constraints and format of financial statement information. Consequently, it has the potential to be much more wide-ranging and future-oriented. The press does not have to wait until transactions, such as revenue-generating transactions, are realized with sufficient reliability to be entered into the financial accounting system, and faces fewer reliability constrains or reporting unrealized gains and losses. Consequently, the press has the potential for considerably greater relevance. However, for the same reasons, the press may be less reliable. Thus, we can think of the financial press as being relevant but perhaps less reliable, while financial statement information is more reliable, but perhaps less relevant. The two information sources therefore complement each other.
4-6.
If securities markets are efficient, comparability is not important providing the market has sufficient information to quickly put different firms’ information on a comparable basis. For this, full disclosure, including disclosure of accounting policies used, is necessary. Then, the market will not be fooled simply because different firms report information on different bases. However, lack of comparability does impose costs on investors to make the necessary adjustments. If these costs are high, say because of poor or lacking disclosure, non-comparable information may not be cost effective and may not be used. Also, if a firm reports information on a basis that is different from most other firms, the market may wonder why. If it feels that the firm has something to hide, it may penalize the firm. If so, lack of comparability would be quite important to the firm involved.