Question 1 (17 marks)HiSpeed Ltd. plans to manufacture cross-cou.docx

Question 1 (17 marks)
HiSpeed Ltd. plans to manufacture cross-country skiing
equipment. Its cash flows are highly dependent on the weather
in early winter. HiSpeed operates under ideal conditions of
uncertainty. On August 1, 2014, the beginning of its first year
in business, HiSpeed acquires equipment to be used in its
operations. The equipment will last two years, at which time its
salvage value will be zero. The company finances the equipment
purchase by issuing common shares.
HiSpeed’s annual net cash flows will be $800 if the weather is
snowy and $300 if it is not snowy. Assume that cash flows are
received at year end. In each year, the objective probability that
the weather is snowy is 0.7 and 0.3 that it is not snowy. The
interest rate in the economy is 3% in both years.
HiSpeed will pay a dividend of $50 at the end of each year of
operation.
Required
a. (9 marks)
In 2014, the weather is snowy. Prepare a statement of financial
position as at July 31, 2015, the end of HiSpeed’s first year of
operations, and an income statement for the year.
b. (2 marks)
What timing of revenue recognition is implicit in the income
statement you have prepared in part (a)? When ideal conditions
do not hold, is this timing of revenue recognition relevant? Is it
reliable? Explain.
c. (6 marks)
Assume that HiSpeed paid the present value you calculated in
part (a) for its equipment. Calculate HiSpeed’s net income for
the year ended July 31, 2015 on a historical cost basis,
assuming that equipment is depreciated on a straight-line basis.

Under the more realistic assumption that ideal conditions do not
hold, which measure of net income is most relevant? Which is
most reliable? Why?
Prem has $2,000 that he wishes to invest for one year. He has
narrowed his choices down to one of the following two actions:
i: Buy bonds of X Ltd., a company that has a very high debt-to-
equity ratio. These bonds pay 8% interest, unless X defaults, in
which case Prem will receive no interest but will recover his
principal. (a1)
ii: Buy Canada Savings Bonds, paying 3% interest. (a2)
Prem assesses the prior probability of X Ltd. defaulting as 0.40.
His utility for money is given by the square root of the amount
of his net payoff. That is, if he buys the Canada Savings Bonds,
his net payoff is $60, yielding utility of √60 = 7.75, and so on.
Prem is a rational decision maker.
Required
a. (4 marks)
Based on his prior probability calculations, which action should
Prem take? Show your calculations.
b. (9 marks)
Before making a final decision, Prem decides he needs more
information. He obtains X Ltd.’s current financial statements
and examines its times-interest-earned ratio. This ratio can be
either high or low. Upon calculating the ratio, Prem observes
that it is low. On the basis of his prior experience in bond
investments, Prem knows the following conditional
probabilities:
Debt-to-Equity Ratio
Future State
Low
High
ND (no default)

0.50
0.50
D (default)
0.05
0.95
Which action should Prem take based on this new information?
Show your calculations; take each step to two decimal places.
c. (5 marks)
An accounting standard (IAS 16) allows X Ltd. to value its
property, plant, and equipment at fair value. The company plans
to adopt this option, since it will reduce its debt-to-equity ratio.
Evaluate (in words — no calculations required) the likely
impact of this adoption on the main diagonal probabilities of the
information system in part (b).
Efficient securities market theory has long been under attack
from behavioural finance, which draws on behavioural theories
of investor behaviour to explain why security prices do not
always behave as the economic theories of rational investing
and market efficiency predict. These attacks have increased
since the 2007-2008 security market meltdowns.
Required
a. (4 marks)
Explain why prospect theory predicts that security prices will
differ from their prices under efficient security markets theory.
b. (4 marks)
Describe two accounting-related efficient securities market
anomalies and, for each, explain why it is an anomaly.
c. (3 marks)
The efficient securities market anomalies suggest that investors
underreact to the full information content of financial
statements. Choose one behavioural theory that predicts this
underreaction and explain why it predicts underreaction.

d. (4 marks)
Should accountants be concerned that the importance of
financial reporting may decline if behaviourally biased
investors do not use all the information in the financial
statements? Explain.Assignment 2 — Session 2 (Winter)
Top of Form
Bottom of Form
This assignment is based on Modules 1 through 7 and is due at
the end of Module 7. It is worth 10% of your final course grade.
Refer to the general instructions in Assignment 1.
Empirical tests of the three hypotheses of positive accounting
theory (PAT) are often based on the amount of discretionary
accruals contained in net income.Required
a. (4 marks)
What are discretionary accruals? Why are they useful in testing
the three PAT hypotheses?
b. (5 marks)
The methodology designed by Jones (1991) (called the Jones
Model) is usually used to estimate discretionary accruals.
Outline in words how the Jones Model measures discretionary
accruals.
c. (4 marks)
For good corporate governance, contracts should be designed
efficiently. A researcher finds, for a sample of firms, that the
covenant slack in debt contracts (the difference between the
critical value of a debt covenant ratio as specified in a debt
contract and the value of that ratio on the borrower’s books on
the date of the contract) is greater on average with greater
variability over time of the debt covenant ratios. Is this finding
evidence of efficient or opportunistic contracting? Explain your
answer.
d. (7 marks)
Discretionary accruals can be used opportunistically or

efficiently. Conservative accounting can be regarded as a form
of discretionary accruals because the firm chooses to report
(that is, accrue) lower asset values and/or higher liability
values. A researcher finds that firms with income escalator
clauses in their debt contracts (an escalator clause increases the
covenant level of net worth the firm is required to maintain
under the contract by a percentage of reported net income) tend
to use more conservative accounting than similar firms with no
escalator clauses in their debt contracts. Is this finding
consistent with efficient or opportunistic contracting? Explain
your answer.
Several accounting standards include ceiling tests (also called
impairment tests).Required
a. (6 marks)
What is a ceiling test? Identify two IASB accounting standards
that contain a ceiling test and describe the test.
b. (6 marks)
Ceiling tests are usually regarded in this course as one-sided
examples of the measurement approach. However, they can also
be regarded as examples of conservative accounting, as assets
are written down but not written up. Ceiling tests are an
example of conservative accounting. Why do bondholders
favour ceiling tests? How do bondholders reward the firm for
conservative accounting such as ceiling tests?
c. (4 marks)
Explain briefly why auditors favour ceiling tests.
d. (4 marks)
Outline the accounting for research and development (R&D)
under IASB standards. Is this accounting conservative? Why?
Explain why accountants account for R&D as they do.
New Century Financial Corp., formed in 1995, was a large
mortgage lender in the United States. Many of these mortgages

were securitized and transferred to investors. New Century
accounted for the proceeds of these securitizations as sales.
However, New Century committed to buy back mortgages that
became troubled within up to a year after transfer.
New Century would retain some mortgages for itself (called
retained interests), from which it would receive future cash
flows. Also, the transfer agreements included the right to
service the mortgages, for which New Century charged a fee.
New Century valued these retained interests and servicing rights
at current value, based on their discounted expected future cash
flows. Thus, revenue from retained interests was recognized at
the time of retention, and servicing revenue was recognized at
the time of mortgage transfer. These policies required numerous
estimates, and contrasted with a more conservative policy of
recognizing revenues as cash flows from retained interests were
received and servicing responsibilities rendered.
The company’s share price increased dramatically, to a high of
US$64 in 2004. Its reported net income reached $1.4 billion in
2005.
However, New Century seriously underestimated the extent of
its mortgage buybacks and resulting credit losses. Of $40
billion of mortgages granted in the first three quarters of 2006,
it provided only $13.9 million for buybacks. Investor concerns
about increasing buybacks rose in 2006 as the 2007-2008
market meltdowns approached. These buyback concerns added
to concerns about early revenue recognition from retained
interests and servicing. Also, the company failed to write down
its retained interests as the current value of the underlying
mortgages decreased.
New Century was soon unable to borrow money to finance
mortgage buybacks. Its shares lost 90% of their value, and the
company was delisted from the New York Stock Exchange. In
April 2007, it filed for bankruptcy protection.
New Century’s auditor (KPMG) was drawn into the lawsuits
that followed. KPMG denied liability, claiming that the
provisions for buybacks were deemed adequate at the time, and

blaming New Century’s failure on the market meltdowns of
2007-2008. In December 2009, the SEC filed civil fraud charges
against three former executives of New Century, seeking
damages and return of bonuses. Several other lawsuits followed.
In November 2010, financial media reported final settlement of
a class action lawsuit that included a payment of over $65
million by former company officers and directors, and a
payment of $44.75 million by auditor KPMG.Required
a. (4 marks)
Use the concept of relevance to defend New Century’s policy of
recognizing revenue as it securitized and sold mortgages. What
was the policy’s major weakness?
b. (4 marks)
Outline a more conservative accounting policy for New
Century’s mortgage sale transactions. Consider both statement
of financial position and net income effects of your policy.
Hint: Read Theory in Practice 8.3, text page 314.
c. (6 marks)
Use two characteristics of investor behaviour based on
psychology to explain the rapid rise in New Century’s share
price. Be sure to identify the specific behavioural
characteristics you draw on in your answer.
d. (4 marks)
Despite your answer in part (c), is the rapid rise in New
Century’s share price necessarily inconsistent with (semi-
strong) securities market efficiency? Explain.
e. (4 marks)
Note that retained interests meet the definition of a financial
instrument. How would these financial instruments be accounted
for under IAS 39?
Paul owns and operates a small, fast-growing business. He
decides to hire a full-time manager. He will then take a year off
to travel, and on his return will concentrate on the technical
aspects of the business.

Martha applies for the job. During her interview, Paul finds that
Martha is risk averse, with utility for money equal to the square
root of the dollar compensation received. She has reservation
utility of 6 and is effort averse, with disutility of effort of 2 if
she works hard (a1), and 1 if she does not work hard (a2).
Paul’s business has, in previous years, earned net income before
manager compensation of $800 75% of the time, and income of
$0 25% of the time. Paul has taken courses in accounting and
has always prepared the financial statements himself. Paul has
always worked hard, and reckons that if he did not work hard
net income would have been $800 only 20% of the time and $0
80% of the time. He expects this earnings pattern to continue
into the future with a new manager. Paul realizes that he must
motivate Martha to work hard, and offers her a one-year
contract, with compensation based on a proportion of net
income before manager compensation.
Note: Take all calculations to two decimal places.Required
a. (6 marks)
What proportion of net income must Paul offer Martha so that
she will accept the position and work hard? Show calculations.
b. (8 marks)
Assuming that Martha accepts Paul’s offer from part (a), show
calculations that verify she will in fact be motivated to work
hard.
c. (4 marks)
Paul realizes that he cannot observe his firm’s unmanaged net
income — he can only observe the net income Martha reports.
He is concerned that Martha will opportunistically manage
earnings while he is away to report net income of $800 while
not working hard. Suggest to Paul how he can reduce the
likelihood that Martha will do this in a one-year contract.
Most firms hedge at least some of their risks. Hedging can take
two basic forms, namely natural hedging and hedging by means
of derivative instruments. The use of derivatives as hedges has

expanded greatly in recent years.
Generally, under accounting standards (IAS 39 and related U.S.
standards), derivative instruments are fair valued with any
unrealized gain or loss included in net income. However, hedge
accounting provides some exceptions to this rule.Required
a. (4 marks)
A firm has a large amount of long-term debt (valued on a cost
basis), and decides to set up a natural hedge of this debt.
However, a natural hedge can lead to excess net income
volatility, that is, net income volatility greater than the actual
volatility of the firm’s operations. Explain how this can happen.
b. (6 marks)
Suggest two ways that the excess net income volatility arising
in part (a) can be prevented.
c. (6 marks)
IAS 39 identifies two basic types of hedge. Describe each type.
For each type, explain how IAS 39 controls excess net income
volatility arising from entering into the hedge.
d. (4 marks)
Use the bonus plan hypothesis of positive accounting theory to
explain why a firm manager dislikes excess net income
volatility. Are the policies to control excess net income
volatility you described in parts (a) and (b) unethical? Explain
why or why not.Assignment 3 — Session 2 (Winter)
Top of Form
Bottom of Form
This assignment is based on Modules 1 through 9 and is due at
the end of Module 9. It is worth 5% of your final course grade.
Refer to the general instructions in Assignment 1.
In July 2011, financial media reported that Glencore
International, plc, a large, Swiss-based multinational producer
of metals, energy, and agricultural commodities, had decided to
stop reporting quarterly financial results from the second
quarter of 2011. Glencore’s first-quarter 2011 sales and

earnings were sharply higher than they were for the same
quarter of the previous year, but it appeared that earnings for
the first quarter still fell short of market expectations.Required
a. (4 marks)
Outline two possible reasons why Glencore reduced its
information production in this manner.
b. (4 marks)
How do you predict that the stock market will react to this
decision by Glencore? Explain.
c. (6 marks)
The covenants in Glencore’s debt contract required the company
to report quarterly. To overcome the rigidity inherent in debt
contracts, Glencore offered to make a cash payment to
consenting bondholders of 0.25% of their holdings, up to a
maximum of $2.4 million, if they agreed to drop the covenant.
If you were a Glencore bondholder, would you accept
Glencore’s offer or not? Explain your reasons.
Income smoothing is a common earnings management pattern.
Many managers feel that their reputations, and their firms’
share prices, are enhanced by a smooth, steadily growing
sequence of reported earnings.Required
a. (4 marks)
A behaviourally biased investor observes a firm’s earnings
increasing steadily over time. The investor decides that this
firm is a growth firm. Identify the specific behavioural bias that
may underlie this investor behaviour and explain why it leads to
identifying the firm as a growth firm. Is the investor necessarily
correct in this identification as a growth firm? Explain why or
why not.
b. (4 marks)
Some firms have used low-persistence accruals to smooth net
income to a level that the firm’s managers felt would persist. Is
this type of earnings management good or bad in terms of
usefulness to equity investors?

Does such smoothing benefit the manager whose compensation
depends on reported net income? Explain why or why not.
c. (5 marks)
A researcher finds that firms that are growing rapidly have, on
average, a lower proportion of manager compensation based on
net income, relative to share-based compensation, than firms
that are not growing rapidly. Explain why. Use concepts of
recognition lag, sensitivity, and precision in your answer.
d. (5 marks)
A firm that has smoothed earnings for many years needs to
manage its earnings upwards this year to maintain the pattern of
smooth, steady earnings that it has been reporting. The firm
anticipates a period of lower earnings next year. Would the firm
manager be wise to smooth earnings this year? Explain why or
why not.
In January 2011, the U.S. Securities and Exchange Commission
(SEC) adopted a requirement that companies give shareholders a
“say on pay” of senior management. This requirement is part of
the implementation of the 2010 Dodd-Frank Wall Street Reform
and Consumer Protection Act, passed by the U.S. congress in
response to the 2007-2008 market meltdowns, including
widespread concerns that senior managers were overpaid.
Shareholders will be asked to vote on executive compensation
packages at least once every three years. The result of the vote
is non-binding on the company. Results of the shareholder vote
must be publicly disclosed.
In Canada, the Ontario Securities Commission is considering
similar requirements.Required
a. (2 marks)
With what theory of executive compensation is say on pay most
consistent? Explain.
b. (6 marks)
The SEC is proposing that the compensation committee of the
board of directors must consist of members independent of

management. Also, the committee will have full authority to
retain consultants, lawyers, and other advisors. Would such
proposals, if implemented, eliminate the need for giving
shareholders a say on pay? Explain.
c. (4 marks)
The expected utility of compensation to a manager can be much
less than the sum of dollar compensation, share, and option
awards. Explain why.
d. (6 marks)
Do you think the “say on pay” requirements and implementation
of the SEC proposals on compensation committee member
independence and freedom to hire advisors will be effective in
increasing the efficiency of executive compensation contracts?
Explain. Define a (second-best) efficient compensation contract
as part of your answer.

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