Why are financial reports important?

Question 1

What are some reasons for why financial reporting is important?

Answer 1

1) for informed decision making
2) to facilitate contracts between parties in terms of financial reporting data. ( e.g. if a ceo’s compensation is tied to firms performance, thus accounting information is useful if you can provide a good measurement of firm performance which can be used to ensure the ceo performs like he is supposed to do.
3) valuation

Question 2

How is financial reporting an answer to the severe problem of asymmetric information in capital markets ( hint use market of lemons argument) where company are trying to attract funds.

Answer 2

Question 3

How do debt investors have a different payoff function to equity holders? ( this is in relation to the fact that different stakeholders of financial information have different needs)

Answer 3

As they demand information on:
1) the value of the firms assets in the event of liquidation
2) the extent of other claims on those assets ( to see hierarchy of order in case of bankruptcy)
3) Firm performance ( to make sure the firm can pay princpal and interest)

Question 4

Will debt investors likely require an independent audit of borrowing firm?

Answer 4

Yes

Question 5

What are equity holders concerned about with financial information?

Answer 5

Concerned with information concerning
1) Current cash flows and the amount
2) timing
3) uncertainty of cash flows
ESSENTIALLY CARE ABOUT A FIRMS PERIODIC PERFORMANCE.

Question 6

Hence we can conclude financial statements trade off information needs of different stakeholders with firms do, is there a system to make sure financial reports are most useful?

Answer 6

Where company has used discretion, different users can argue and tailor this to their needs.

Question 7

In a perfectly efficient world what is the definition of firm value?

Answer 7

Present value of the expected future cash flows, discounted at the appropriate risk adjusted rate of return.

Question 8

In competitive market firms with either supernormal or sabnormal profits are expected to converge towards the mean, except when?

Answer 8

firms that possess a competitive advantage can protect themselves against compeititon. However this profitability sustainability may arise from opportunistic accounting choices.

Question 9

What is the residual income model?
What is terminal value?

Answer 9

It is a measure that captures the value added abnormal returns.
The book value of equity + PV of expected future abnormal earnings + Present value of the terminal value.
So terminal value is the estimated value of a business beyond the explicit forecast period.

Question 10

Where is the residual income derived from?

Answer 10

The clean surplus relation
Book value of equity today = Beg Book value + NI ( CI) - d( net dividends)

Question 11

What is the RI in the RI model

Answer 11

what its saying if i have a 1million dollars of equity invested in my business and my investors demand a 10% return, they only invest in my business because they think i will generate a 10% return, hence they expect me to make a return of 100000 dollars each year, if my actual return is 150000, it generates RI of 500000, so i earned more than cost of capital

Question 12

Residual income can also be expressed in what?

Answer 12

ROE OR ROCE

Question 13

How can the impact of different accounting policies effect the calculation of residual income?

Answer 13

Valuations are based on earnings and book values, in which accounting choices affect earnings and book values.

Question 14

So terminal value is the estimated value of a business beyond the explicit forecast period.
Discuss these 3 cases?

Answer 14

1) TV = 0 when we are in a really competitive business, companies only generate return = cost of capital, so no RI.
2) We maintain a constant RI in the future, so when a company believes it will maintain a competitive advantage in the future
3) Represents growth in our RI model but re>g.

Question 15

{CASE STUDY ANALYSIS} Kansas City Zephyrs Baseball Club, Inc.
What is the summary of the case study analysis?

Answer 15

What happened was that players and the owner of the baseball club had dispute of the profitability of the baseball club. The owner said they were losing money, whereas the players said they were in profit. They had made financial statements to support decision. Bill Ahern had to sit in office ( external arbitrator) in to settle the dispute

Question 16

What are the 3 main areas of dispute?

Answer 16

Player compensation
Roster depreciation
Stadium expense

Question 17

What is the owners view on Player compensation? ( i.e Base salaries, Signing bonus and Deferred compensation and non-roster guaranteed contract? )
What are the players view on Base salaries, Signing bonus and Deferred compensation and non-roster guaranteed contract ( hint they retired early) ?

Answer 17

expense all roster players compensation and amounts guaranteed to non-roster players in the current year.

Base salaries and cash-bonuses: expense in the current year
Signing bonus: amortized over contract life
Deferred compensation and non-roster guaranteed contract:
expense as incurred

Question 18

What does GAAP say about this?

Answer 18

Question 19

What is the economic reality of Player compensation? ( Hint non-roaster guranteed contract is the only change)

Answer 19

Question 20

What is a reserve?

Answer 20

is a contra asset account on a company’s balance sheet made in anticipation(estimation) when there is a loss or that an item will not be able to be sold. When the loss is fully recognised, its written down as an official loss in e.g. inventory or like revenue.

Question 21

{CASE STUDY ANALYSIS} Kansas City Zephyrs Baseball Club, Inc. Now lets look at players depreication?
What do the owners believe about the players depreciation? What do players believe about depreciation?

Answer 21

Question 22

With players depreication what does GAAP say and what is the economic reality ?

Answer 22

Question 23

What are the owners and players views on stadium costs and what is the economic reality and what would GAAP say?

Answer 23

Question 24

Why might it be the case that the stadium costs worked out are different especially for Players and owners?

Answer 24

Incentives are misaligned, by owners charging all stadium costs to business it aligns there incentives as opposed to players, who want to achieve profit.

Question 25

What is transfer pricing?

Answer 25

The price charged by the selling division to the buying division for an intermediate product.

Question 26

What can we conclude from the kansas case?

Answer 26

Economic reality is difficult to capture under a single neutral rule, specially when different financial statement users have different needs (Equity holders vs creditors, preparers vs users,
etc)
Accounting rules provide discretion. Some discretion is good as
it enables preparers of financial statements to communicate the
economic reality of their businesses better (r, whenever there is discretion, preparers of financial
statements might be inclined to use it in their own interest)

Question 27

Should accounting standards allow for managerial discretion?
Provide arguments for and against and use examples from the
case study Zephyrs Baseball Club.

Answer 27

tba

Question 28

What is the role of accrual accounting ? Discuss with reference
to the case study Zephyrs Baseball Club.

Answer 28

companies record revenue when it is earned, not when the company collects the money.

Question 29

Can accounting neutrality be achieved? Discuss with reference
to at least 3 groups of users of financial statements. In your
answer, refer to the case study Zephyrs Baseball Club.

Answer 29

tba