Deck 8: Usefulness of Accounting Information to Investors and Creditors

Question 1

Economic profit is sometimes referred to as abnormal earnings.

Answer 1

False

Question 2

Most testing of the efficient-markets hypothesis has dealt only with past information reflected in security prices.

Answer 2

False

Question 3

The FASB has implicitly adopted the cash flow valuation model.

Answer 3

True

Question 4

In portfolio theory, systematic risk is defined as the variance of expected investment returns.

Question 5

According to portfolio theory, systematic risk can be reduced by holding a portfolio of investments.

Question 6

The efficient-markets hypothesis refers to the speed with which financial analysts are able to predict a firm's cash flows.

Question 7

The theoretical foundation of capital market or security price research comes from the efficient-markets hypothesis.

Question 8

The calculation of residual income recognizes that equity, but not debt, has a cost.

Question 9

Residual income refers to income in excess of a charge for the capital that is employed to generate that income.

Question 10

The FASB maintains that accrual accounting systems are more useful for predicting net cash flows than are simpler cash-based systems.

Question 11

Residual income can be used as a company and intra-company performance measurement tool.

Question 12

In the capital asset pricing model, beta is used to represent systematic risk of individual securities and to predict the risk-based price of securities.

Question 13

According to the clean surplus accounting, ending book value of equity equals beginning book value plus earnings.

Question 14

Economic income is equal to residual income.

Question 15

Economic profit is equal to net operating profit less taxes paid minus a charge on invested capital.

Question 16

Unlike stock price, which is forward looking, residual income focuses on historical performance.

Question 17

The expected portfolio return decreases as risk increases.

Question 18

The assumption of the capital asset pricing model is that individual securities are priced solely on unsystematic risk.

Question 19

The underlying premise of the clean surplus accounting is that all profit and loss elements go through income.

Question 20

The value to investors of the information in financial reporting lies in its role as an historical record.

Question 21

The relationship between earnings and stock prices has diminished over the years, but the ability of earnings to forecast futures cash flows has not.

Question 22

The strongest evidence from capital market research concerns the information content of annual accounting earnings numbers.

Question 23

The relationship between risk and return for diversified portfolios is modeled by the Security Market Line (SML).

Question 24

Research studies have predominantly supported the naive-investor hypothesis.

Question 25

It may be assumed that accounting information has no usefulness to investors because many individual stockholders do not read annual reports.

Question 26

When accounting numbers are used to monitor agency contracts, there can be indirect consequences from changes in accounting policies.

Question 27

Which of the following is not true regarding earnings and dividends?

A) Managers adjust dividends primarily to reflect the change in current earnings.
B) Stock price may be modeled as the present value of future expected dividends.
C) Investors regard cash dividends as credible signals of future performance.
D) Current income has a value in predicting future dividends.

Question 28

Because post-earnings-announcement drift shows that there is at least some amount of efficiency in the market, it is even more important to attempt to improve the quality of accounting standards.

Question 29

Post-earnings-announcement drift refers to the fact that it takes up to 90 days for security prices to react significantly to earnings announcements.

Question 30

The study by Ou and Penman, which used traditional accounting measures to predict whether a company's income would increase or decrease, indicated that markets are not as efficient as previously thought, and that fundamental analysis is important for investment purposes.

Question 31

Excess income over and above the expected amount of after-tax operating income is called:

A) Extraordinary Profit
B) Remaining Profit
C) Economic Profit
D) Monetary Profit

Question 32

Capital market research has shown that investors do not appear to adjust accounting income to compensate for artificial bookkeeping differences.

Question 33

Surveys of individual investors have generally indicated a high readership of accounting information.

Question 34

Which of the following would be an argument in favor of using residual income models in performance measurement?

A) All forms of residual income are consistent with discounted net cash flows for any method of depreciation.
B) Residual income focuses on historical performance.
C) The determination of residual income is dependent on an accurate estimate of the cost of capital.
D) Residual income recognizes that all capital, debt as well as equity, has a cost.

Question 35

Accounting-based ratios have not been very useful in discriminating between firms that subsequently went bankrupt and those that did not.

Question 36

The study by Lev that examined earnings numbers and stock returns found a high explanatory relationship between earnings and stock returns.

Question 37

Which of the following is true regarding the term residual income?

A) Residual income is the income over and above the amount needed to cover current expenses.
B) Residual income is the income in excess of a charge for the capital that is employed to generate that income.
C) Residual income is equal to economic income.
D) Residual income is called abnormal earnings when applied to the enterprise's operating income and invested capital.

Question 38

Accounting information ranks at the top on surveys that ask investors to weigh the importance of different types of investment information.

Question 39

Which of the following is not a true statement?

A) There is empirical evidence that future cash flows are better forecasted with accrual data than with cash flow data.
B) Accrual accounting numbers incorporate the attribute that determines firm valuation-net cash flow data.
C) Changes in reported accounting earnings affect firm valuation through changes in stock prices.
D) The value to investors of the information in financial reporting lies in its role as an historical record.

Question 40

The usefulness of accounting information may be determined by directly asking investors how they use annual reports.

Question 41

Which of the following is not a possible cause of post-earnings-announcement drift?

A) Financial analysts overreact to fundamental signals stemming from securities.
B) Shareholders do not distinguish well between the cash flow portions and the accrual portions of earnings.
C) Financial analysts' forecast errors lead to incomplete security price adjustments.
D) Transaction costs are too high relative to the potential gain that can be earned from the mispricing of the securities.

Question 42

Which of the following applies to the clean surplus theory?

A) It is a theory that is applied to security valuation, but is not very attuned to accounting concepts and numbers.
B) The theory values a firm's equity based on the beginning of the period book value plus the present value of expected future abnormal earnings.
C) The theory considers a firm's abnormal earnings amount to be equal to its beginning of the period book value multiplied by the cost of equity capital.
D) This theory does not tie in well with the FASB's concept of comprehensive income.

Question 43

Which of the following is a finding of previous capital market research studies?

A) The market is not fooled by arbitrary accounting numbers.
B) The direction of change in reported accounting earning is inversely correlated with security price movements.
C) The market is affected by alternative accounting income numbers that do not affect cash flow, such as those related to a change from deferral to recognition of unrealized holding gains on marketable securities.
D) Security prices are affected by a change from the deferral to flow-through method of accounting for the investment credit.

Question 44

The three forms of the efficient-markets hypothesis are:

A) Weak, semistrong, strong.
B) Slow, quick, instantaneous.
C) Past, current, future.
D) Private, semipublic, public.

Question 45

Which of the following is a possible reason why security prices were found to respond to changes from pooling to purchase accounting for combinations?

A) A change from pooling to purchase accounting does not affect cash flow
B) Differences between purchase and pooling accounting affect only book income
C) The change could have affected dividend distribution because of debt covenants
D) Income would normally be higher under purchase accounting than pooling

Question 46

Which of the following are possible sources of abnormal earnings?

A) Recognizing the positive excess present value above the cost of a project on the balance sheet
B) The use of current values in reporting marketable securities
C) Conservative matching and recognition procedures under historical costing
D) All of the above

Question 47

Which of the following is not a finding or conclusion of the research study by Ou and Penman that used traditional accounting measures to predict whether a company's income would increase or decrease?

A) The researchers were unable to describe the following year earnings changes correctly in most cases.
B) Markets are not as efficient as efficient-market advocates would like to believe.
C) Better accounting standards might improve the predictive ability of accounting information.
D) Fundamental analysis is still important for investment purposes.

Question 48

Which of the following would give rise to abnormal earnings?

A) Accelerated depreciation
B) LIFO costing for inventories and cost of goods sold
C) Immediate write-off of research and development
D) All of the above

Question 49

Which of the following findings would support the naive-investor hypothesis?

A) A finding that security prices respond to income levels that differ solely because of alternative accounting methods with no cash flow consequences
B) A finding that security prices do not respond to artificial book-income differences
C) A finding that security prices do not respond to the adoption of LIFO for accounting for inventories and cost of goods sold
D) A finding that security prices do not respond to a change in reported accounting earnings from the prior year

Question 50

Which of the following statements does not apply to the market model?

A) It is a simpler approach than the standard version of the capital asset pricing model.
B) This approach is seldom used in accounting research.
C) In this model, the risk-free return is dropped from the equation.
D) Abnormal returns are captured in the error term of the model.

Question 51

Which of the following statements is true regarding post-earnings-announcement drift?

A) Security prices do not react significantly at the time of earnings announcements.
B) At least part of the blame for this effect has been laid at the feet of financial analysts.
C) This effect is more important for larger firms than for smaller firms.
D) Security prices never fully reflect the effects of earnings announcements.

Question 52

In security-price research, which of the following is an indirect consequence of an accounting policy change?

A) The value of the firm is affected through an effect on cash flow.
B) The value of the firm is affected through an effect on net income.
C) The value of the firm is affected through an effect on owners.
D) The value of the firm is not affected.

Question 53

Which of the following statements does not apply to the study by Lev that examined earnings numbers and stock returns?

A) According to Lev, over time, the correlation between earnings numbers and stock returns has been low.
B) Lev believed that earnings have very little explanatory power relative to changes in stock prices.
C) Lev believed that one of the primary reasons for the level of correlation between earning and stock returns lies with the low quality of reported income numbers.
D) The study's results contradicted those of the Ou and Penman study.

Question 54

Early advocates of security-price research now recognize there are limitations to this research for use in choosing the best accounting policies and evaluating the economic consequences of alternative accounting policies on security prices. Which of the following is not a reason for these limitations?

A) The public-good nature of accounting information
B) The existence of free riders
C) The resultant market failure in terms of optimal resource allocation
D) The use of historical costing distorts financial statement amounts

Question 55

Which of the following statements does not apply to portfolio theory?

A) It is the foundation for the capital asset pricing model.
B) It is the foundation for capital market or security price research.
C) It holds that risk can be eliminated by holding a portfolio of investments.
D) It is a theory of rational investment choice and utility maximization.

Question 56

Which of the following is not true regarding capital market research?

A) Studies have found a low correlation between the variability of accounting earnings and beta.
B) Studies have found a strong association between accounting-based ratios and the market measure of risk.
C) Studies have found that supplemental segment (line of business) disclosures resulted in a revision of systematic risk, indicating that such information is useful for risk assessments.
D) At least one study has found that pension information is not useful for risk assessments.

Question 57

Which of the following statements applies to the capital asset pricing model?

A) It assumes that individual securities are priced solely on unsystematic risk.
B) It uses beta to represent unsystematic risk of individual securities.
C) It assumes that if the rate of return on an individual security is greater than the market average, systematic risk of the security must be smaller.
D) It assumes that if beta equals 1, the systematic risk of an individual security is equal to the average risk of the market as a whole.

Question 58

Which of the following statements is not supported by empirical evidence from capital market research?

A) Accounting earnings appear to have information content and to affect security prices.
B) Alternative accounting policies with no apparent direct or indirect cash flow consequences to the firm do not seem to affect security prices.
C) There are no incentives to choose certain alternative accounting policies over others because there are never cash consequences.
D) Accounting-based risk measures correlate with market risk measures, suggesting that accounting numbers are useful for risk assessment.

Question 59

Which of the following is an assumption of fundamental analysis?

A) Securities markets are efficient.
B) Prices of securities rapidly reflect all publicly available information.
C) The strong form of the efficient-markets hypothesis is true.
D) Under-priced shares can be found in the securities market by means of financial statement analysis.

Question 60

Which of the following ranks below annual reports on surveys that ask investors to weigh the importance of different types of investment information?

A) Information from company reports
B) Information about general economic conditions
C) Company announcements on products and markets
D) None of the above rank below annual reports

Question 61

Discuss the results of the study by Loh and Mian as they relate to the importance of earnings forecasting.

Question 62

What is post-earnings-announcement drift, and what are possible causes for this phenomenon?

Question 63

Respond to the following:
a.
Describe the capital asset pricing model.
b.
What is the market model?

Question 64

What are the weaknesses of capital market research?

Question 65

What is cross-sectional valuation and how has this approach been used in research studies?

Question 66

Respond to the following:
a.
What is meant by market efficiency?
b.
What does the efficient-markets hypothesis imply about the value of accounting information?
c.
Describe the three forms of the efficient-markets hypothesis.

Question 67

Discuss whether alternative accounting policies have a systematic effect on security prices and what this implies about the information content of accounting policy changes. Include a discussion of previous research in this area.

Question 68

What is the underlying premise of clean surplus theory and how is it applied in determining the valuation of a firm's equity?

Question 69

The research approach that examines the association between accounting data reported in annual financial statements and the levels of stock prices is called:

A) Cross-sectional valuation
B) Investor survey analysis
C) Accounting information usefulness research
D) Time series analysis