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CHAPTER 4

Case 4-1

Investors wish to use accounting information to minimize risk and to maximize returns. The
capital asset pricing model (CAPM) is an attempt to deal with both risks and return. The rate
of return to an investor from buying a common stock and holding it for a period of time is
calculated by adding the dividends to the increase (or decrease) in value of the security during
the holding period and dividing this amount by the purchase price of the security or

dividends + increase (or - decrease) in value

purchase price

Some risk is peculiar to the common stock of a particular company. For example, a
company's stock may decline in value because of the loss of a major customer such as the
loss of Hertz as a purchaser of rental cars by the Ford Motor Company. On the other hand,
overall environmental forces cause fluctuations in the stock market that impact on all stock
prices such as the oil crisis in 1974. These two types of risk are termed unsystematic risk and
systematic risk. Unsystematic risk is that portion of risk peculiar to a company that can be
diversified away. Systematic risk is the nondiversifiable portion which is related to overall
movements in the stock market and is consequently unavoidable.

As securities are added to a portfolio unsystematic risk is reduced. Empirical research has
demonstrated that unsystematic risk is virtually eliminated in portfolios of 30-40 randomly
selected stocks. However, if a portfolio contains many common stocks in the same or related
industries, a much larger number of stocks must be acquired.

An additional assumption of the CAPM is that investors are risk averse; consequently,
investors will demand additional returns for taking additional risks. As a result, high risk
securities must be priced to yield higher expected returns than lower risk securities in the
marketplace.

A simple equation can be illustrated to express the relationship between risk and return. This
equation uses the risk free return (the Treasury Bill rate) as its foundation and is stated:

Rs = Rf + Rp

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Where:

Rs = The expected return on a given risky security

Rf = The risk free rate
Rp = The risk premium

Since investors can eliminate the risk associated with acquiring a particular company's
common stock by acquiring diversified portfolios, they are not compensated for bearing
unsystematic risk. And, since well diversified investors are only exposed to systematic risk,
investors using the CAPM as the basis for acquiring their portfolios will only be subject to
systematic risk. Consequently, the only relevant risk is systematic risk and investors will be
rewarded with higher expected returns for bearing market-related risk that will not be affected
by company specific risk.

The measure of the parallel relationship of a particular common stock with the
overall trend in the stock market is termed Beta (β). β may be viewed as a gauge of a
particular stock's volatility to the volatility of the total stock market.

A stock with a β of 1.00 has a perfect relationship to the performance of the overall market as
measured by a market index such as Dow-Jones Industrials or the Standard and Poor's 500 -
stock index. Stocks with a β of greater than 1.00 tend to rise and fall by a greater percentage
than the market; whereas, stocks with a β of less than 1.00 are less likely to rise and fall than
is the general market index. Therefore, β can be viewed as a particular stock's sensitivity to
market changes, and as a measure of systematic risk.

Case 4-2

a. In the supply and demand model, price is determined by (1) the availability of the
product (price) and (2) the desire to possess that product (demand). The assumptions
of this model are:

1. All economic units possess complete knowledge of the economy.

2. All goods and services in the economy are completely mobile and can be easily
shifted within the economy.
3. Each buyer and seller must be so small in relation to the total supply and demand
that neither has an influence on the price or demand in total.
4. There are no artificial restrictions placed on demand, supply, or prices of goods
and services.

b. The securities market is considered the best example of the supply and demand
model because stock exchanges provide a relatively efficient distribution system and
information concerning securities is available through many different outlets.

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c. The efficient markets hypothesis holds that the price of a security is determined by
the purchaser's knowledge of available relevant information about that security.
According to this theory, the market for securities can be described as efficient if it
reflects all available information and reacts instantaneously to new information. The
three forms of the efficient market hypothesis differ in their definitions of all
available information as follows:

Weak form - Available information consists of past price history of the

security.
Semi-strong form - Available information includes past price history and all other
publicly available information.
Strong form - Past price history, all publicly available information and
insider information.

Case 4-3

a. Calendar anomalies are related with particular time periods i.e. movement in stock prices
from day to day, month to month, year to year etc. Following are examples of calendar
anomalies:
Calendar anomalies Description
1. Weekend Effect: Stock prices are likely to fall on Monday;
consequently, the Monday closing price is
less than the closing price of previous
Friday.
2. Turn-of-the-Month Effect: The prices of stocks are likely to increase on
the last trading day of the month, and the
first three days of next month.
3. Turn-of-the-Year Effect The prices of stocks are likely to increase
during the last week of December and the
first half month of January
4. January Effect: Small-company stocks tend to generate
greater returns than other asset classes and
the overall market in the first two to three
weeks of January.

For many years, it has been argued that value strategies outperform the market.
Value strategies consist of buying stocks that have low prices relative to earnings,
dividends, the book value of assets or other measures of value.

Following are examples of value anomalies:

Value anomalies Description

1. Low Price to Book Stocks with low market price to book value
ratios generate greater returns than stocks

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 having high book value to market value
ratios.
2. High Dividend Yield Stocks with high dividend yields tend to
outperform low dividend yield stocks.
3. Low Price to Earnings (P/E) Stocks with low price to earnings ratios are
likely to generate higher returns and
outperform the overall market, while the
stocks with high market price to earnings
ratios tend to underperform the overall
market.
4. Neglected Stocks Prior neglected stocks tend to generate
higher returns than the overall market in
subsequent periods of time. While the prior
best performers tend to underperform the
overall market.

Technical analysis is a general term for a number of investing techniques that attempt
to forecast security prices by studying past prices and other related statistics.
Common technical analysis techniques include strategies based on relative strength,
moving averages, as well as support and resistance. Following are examples of
technical anomalies

Technical anomaly Description

1. Moving Average A trading strategy which involves buying
stocks when short-term averages are higher
than long-term averages and selling stocks
when short-term averages fall below their
long-term averages.
2. Trading Range Break A trading strategy which is based upon
resistance and support levels. A buy signal is
created when the prices reaches a resistance
level. A selling signal is created when prices
reach the support level.

There are also several other types of anomalies that cannot be easily categorized.
Examples of these anomalies are:

Other Anomalies Description

1. The Size Effect Small firms tend to outperform larger firms.
2. Announcement Based Effects and Price changes tend to persist after initial
Post-earnings Announcement Drift announcements. Stocks with positive
surprises tend to drift upward, those with
negative surprises tend to drift downward.
3. IPO's, Seasoned Equity Offerings, Stocks associated with initial public
and Stock Buybacks offerings (IPOs) in tend to underperform the

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 market and there is also evidence that
secondary offerings also underperform.
Whereas, stocks of firms announcing stock
repurchases outperform the overall market
in the following years.
4. Insider Transactions There is a relationship between transactions
by executives and directors in their firm's
stock and the stock's performance. These
stocks tend to outperform the overall
market.
5. The S&P Game Stocks rise immediately after being added to
S&P 500

b. Behavioral finance explores the proposition that investors are often driven by
emotion and cognitive psychology rather than rationale economic behavior. It
suggests that investors use imperfect rules of thumb, preconceived notions, bias-
induced beliefs and behave irrationally. Consequently, behavioral finance theories
attempt to blend cognitive psychology with the tenets of finance and economics to
provide a logical and empirically verifiable explanation for the often observed
irrational behavior exhibited by investors. The fundamental tenet of behavioral
finance is that psychological factors, or cognitive biases, affect investors, which
limits and distorts their information and may cause them to reach incorrect
conclusions even if the information is correct.

c. Some of the most the most common cognitive biases in finance are:

Mental accounting - The majority of people perceive a dividend dollar differently

from a capital gains dollar. Dividends are perceived as an addition to disposable
income; capital gains usually are not.

Biased expectations - People tend to be overconfident in their predictions of the

future. If security analysts believe with an 80% confidence that a certain stock will go
up, they are right about 40% of the time. Between 1973 and 1990, earnings forecast
errors have been anywhere between 25% and 65% of actual earnings.

Reference dependence - Investment decisions seem to be affected by an investor’s

reference point. If a certain stock was once trading for $20, then dropped to $5 and
finally recovered to $10, the investor’s propensity to increase holdings of this stock
will depend on whether the previous purchase was made at $20 or $5

Representativeness heuristic. In cognitive psychology this term means simply that

people tend to judge “Event A” to be more probable than “Event B” when A appears
more representative than B. In finance, the most common instance of
representativeness heuristic is that investors mistake good companies for good stocks.

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 Good companies are well-known and in most cases fairly valued. Their stocks,
therefore, may not have a significant upside potential.

Case 4-4

The deductive approach to the development of a theory begins with the establishment of
certain objectives. Once the objectives have been identified, key definitions and assumptions
are stated. the researcher then develops a logical structure for accomplishing the objectives,
based on the definitions and assumptions. Political economy theory is an example of
deductive theory formation in that it stresses that the objective of accounting should not be
the benefit of one group over another and recommends viewing market and socio-economic
forces in the development of accounting theory. Agency theory is also a normative theory in
that it attempts to explain behavior.

The inductive approach to the development of a theory emphasizes making observations and
drawing conclusions from those observations. It is going from the specific to the general.
Under this approach the researcher generalizes about the universe based upon a number of
observations of specific situations. APB Statement No. 4 was an example of inductive
research in that it described GAAP on the basis of observations about current practice.

The pragmatic approach to theory development is based on the concept of utility or

usefulness. That is, once a problem has been identified, the researcher attempts to find a
utilitarian but not necessarily a optimum solution. A Statement of Accounting Theory by
Sanders, Hatfield and Moore was an example of the pragmatic approach to theory
development in that it essentially recommended to accountants "do what you think best."
This study was used by some accountants as an authoritative source that justified current
practice.

Case 4-5

The basic assumption of agency theory is that individuals maximize their own expected
utilities. It attempts to explain behavior in terms of the benefit to be derived from a particular
course of action. Inherent in agency theory is the assumption that there is a conflict of
interest between the owners of a firm (shareholders) and the managers because managers are
maximizing their own utilities which does not result in a maximization of shareholder wealth.
An agency is defined as a relationship by consent between two parties whereby one party
(agent) agrees to act on behalf of the other party (principal). According to agency theory, the
political process has an impact on agency relationships because political officials frequently
believe that inefficient markets can only be remedied by government intervention. Agency
theory may help to explain the absence of a comprehensive theory of accounting because of
the diverse interests involved in financial reporting; however, it will not help to identify the
correct accounting procedures because it only attempts to explain the state of current practice
not the best methods of practice.

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Case 4-6

Studies attempting to assess an individual's ability to use information are termed human
information processing research. In general, this research has indicated that individuals have
a limited ability to process large amounts of information. The main consequences of this
finding are:

1. An individual's perception of information is selective. That is, since individuals are

capable of comprehending only a small part of their environment, their anticipation of
what they expect to perceive about a particular situation will determine to a large extent
what they do perceive.

2. Since individuals make decisions on the basis of a small part of the total information
available, they do not have the ability to make optimal decisions.

3. Since individuals are incapable of integrating a great deal of information, they process
information sequentially.

If these conclusions are correct, the current focus on disclosure by the FASB may have an
effect opposite to what is intended. That is, the annual reports may already contain more
information than can be processed by individuals.

Case 4-7

a. Critical perspective research rejects the view that knowledge of accounting is

grounded in objective principles. Rather researchers adopting this viewpoint share a
belief in the indeterminacy of knowledge claims. This indeterminacy view rejects the
notion that knowledge is externally grounded and is only revealed through systems of
rules that are superior over other ways of understanding phenomena. These
researchers attempt to interpret the history of accounting as a complex web of
economic, political and accidental co-occurrences. They have also argued that
accountants have been unduly influenced by one particular viewpoint in economics
(utility based, marginalist economics). This economic viewpoint holds that business
organizations trade in markets that form a part of a society's economy. Profit is the
result of these activities and is indicative of the organization's efficiency in using
society's scarce resources. In addition, these researchers maintain that accountants
have also taken as given the current institutional framework of government, markets,
prices and organizational forms with the result that accounting serves to aid certain
interest groups in society to the detriment of other interest groups.

b. Critical perspective research views mainstream accounting research as being based

upon the view that there is a world of objective reality that exists independently of
human beings which has a determinable nature that can be observed and known
through research. Consequently, individuals are not seen as makers of their social
reality, instead they are viewed as possessing attributes that can be objectively
described (i.e. leadership styles or personalities). The critical perspectivists maintain

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 that mainstream accounting research equates normative and positive theory. That is,
what is and what ought to be are the same. It is also maintained that mainstream
accounting research theories are put forth as attempts to discover an objective reality,
and there is an expressed or implied belief that the observed phenomena are not
impacted by the research methodology. In summary, mainstream accounting
research is based upon a belief in empirical testability.

c. In contrast, critical perspective research is concerned with the ways societies, and the
institutions that make them up, have emerged and can be understood. Research from
this viewpoint has been claimed to be based on three assumptions:

1. Society has the potential to be what it is not.

2. Conscious human action is capable of molding the social world to be something
different or better.
3. No. 2 can be promoted by using critical theory.

Case 4-8

a. No. Financial reporting should be neutral. According to SFAC No. 5, neutrality

means that in either formulating or implementing accounting standards, the primary
concern should be the relevance and reliability of the information being provided, not
the effect that the accounting standards will have on a particular interested party.
That is, accounting information should be free from bias toward a predetermined
result. Neutrality implies that accounting information reports economic activity and
financial position as faithfully as possible without attempting to influence behavior in
some particular direction. Accounting information that is not neutral loses
credibility.

Employers who provide postretirement and postemployment benefits presumably do

so because the employees earned these benefits while they worked. If so, these costs
accrue during the employment period. When they are accounted for, accrual or pay-
as-you-go, does not affect the amount and timing of the future payments.
Management decisions should be based on how they affect cash flows, i.e., their
economic impact, not on how accountants report economic events.

b. Arguably, there are social costs associated with the accounting for postemployment
and postretirement benefits. If management reacts to the accounting change be
curtailing benefits, the cost is real and obvious. Employees will not receive benefits
as they did before. Other possible costs might include agency costs such as
management compensation or debt covenant agreements. If management’s
compensation is based on net income, expensing the cost of providing these benefits
early will reduce net income and management’s bonus. Reporting previously
unreported liabilities for future benefit payments would negatively affect debt-to-

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 equity ratios that may be perceived by the stock market as increased risk and may
violate existing debt covenant agreements.

c. Critical perspective proponents would argue that the social costs (see b.) outweigh
the benefits, if any, of reporting postemployment benefits and postretirement benefits
in accordance with the new pronouncements.

d. Mainstream accounting proponents would argue that the role of accounting is to

report unbiased information. Accounting should report economic circumstances and
events as they are and should not present information to achieve a particular result.
They would argue that not to report the information required because of potential
social costs would be to present financial information that was biased and thus not
neutral, thereby violating the neutrality concept. They would also argue that the user
needs to know the potential cost of these benefits and therefore reporting them in
accordance with the new pronouncements is relevant to user decision making.

Case 4-9

a. Liabilities are defined as probable future sacrifices of economic benefits arising from
present obligations of a particular entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events. Capital leases meet this
definition; hence they represent claims to resources.

Liabilities are to be measured at the present value of future cash flows discounted at
the effective rate of interest. This measurement requirement is consistent with the
accounting of capital leases. Investors, creditors and other users recognize liabilities
as requiring the use of cash in the future, hence, reporting liabilities at the present
value of future cash flows provides information for user predictions of future cash
outflows. While it is true that reporting the anticipated future cash flows in footnotes
would also provide users with information to predict future cash flows, simultaneous
reporting of the present value of those future cash flows as a liability on the balance
sheet underscores the fact that there is a present claim to company resources.

Also, lease capitalization reports an asset that was essentially purchased. This
treatment is consistent with that of other purchased assets. The leased asset provides
the same services as a purchased asset. It will provide future benefit over its useful
life or the lease term and hence meets the definition of an asset. Reporting its value
as an asset meets the conceptual framework’s objective of providing information
regarding a company’s resources. Simply listing the expected future lease payments
in a footnote tends to obscure the fact that there is an asset and that the asset provides
future benefit which presumably will be associated with future cash inflows.

b. The semi-strong form of the EMH implies that all publicly available information is
impounded in security prices. Since the cash flows are the same whether the lease is

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 capitalized or not, and those cash flows would be public information regardless of
whether the lease were capitalized or described in the footnotes, the market would
instantaneously impound the information into the stock prices in the same way under
either accounting approach as soon as the information became public.

c. Agency theory would predict that managers would choose accounting procedures that
would increase assets, increase earnings, or decrease debt. The higher debt is to
equity the more likely the company will breach existing debt covenants.
Management is expected to act in a manner that would reduce associated agency
costs. Lease capitalization would increase assets, but it would also increase debt.
Hence, agency theory would predict that management would have a tendency to
structure lease agreements so that the debt would not be reported on the balance sheet
- i.e., management would not want to capitalize leases.

FASB ASC 4-1 Employee Stock Options

Information on stock compensation is contained in FASB ASC 718-10. It can be

accessed through the expense topic field or by searching share based payments.

Room for Debate

Debate 4-1 The Efficient Market Hypothesis and Accounting Information

Team 1 Given the EMH, argue that accounting is relevant

The three forms of the efficient market hypothesis (EMH) are the weak form, the
semi-strong form, and the strong form. According to the weak form, the historical
price of a stock provides an unbiased estimate of the future price of the stock. Hence,
an investor cannot make excess gains by knowledge of prior prices. But, an investor
could gain if he/she has other knowledge regarding expected future performance of a
company, e.g., accounting information. Under this form of the EMH, accounting
information is definitely relevant.

According to the semi-strong form of the EMH, all publicly available information is
instantaneously impounded into security prices. Hence, publicly available
information, such as publicly released accounting information is already reflected in
the price of a share of stock, and knowledge of this information would not provide an
advantage to any potential investor. In this case only insider information, e.g.,
accounting information which is not released to the public, would benefit the
potential investor. Yet there are restrictions on insider trading of stocks.

Nevertheless, insider information is still useful for other purposes. It is used for
planning and strategy for the corporation. It is used in labor negotiations. It is used
for the preparation of income tax returns. Many users use the information

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 According to the strong form of the EMH, all information is impounded into security
prices. Under this theory, even insiders could not benefit from knowledge of
nonpublic information. But accounting information would still be useful to lenders,
and a host of other users.

Team 2 Given the EMH, argue that accounting information is irrelevant

The three forms of the efficient market hypothesis (EMH) are the weak form, the
semi-strong form, and the strong form. According to the weak form, the historical
price of a stock provides an unbiased estimate of the future price of the stock. Hence,
an investor cannot make excess gains by knowledge of prior prices. Under this form
of the EMH it is not possible to argue that accounting information is irrelevant. An
investor could gain if he/she has other knowledge regarding expected future
performance of a company, e.g., accounting information. Under this form of the
EMH, accounting information is definitely relevant.

According to the semi-strong form of the EMH, all publicly available information is
instantaneously impounded into security prices. Hence, publicly available
information, such as publicly released accounting information is already reflected in
the price of a share of stock, and knowledge of this information would not provide an
advantage to any potential investor. If this is so, investors would not have
information that is not publicly available and accounting information would be
irrelevant. They could do just as well picking stock randomly.

According to the strong form of the EMH, all information is impounded into security
prices. No information, even accounting information which is not available to the
public, would provide an advantage to any investor over other investors. Hence,
accounting information would not be relevant.

Debate 4-2 Critical perspective versus mainstream accounting

Team 1 Present arguments supporting critical perspectives research.

Critical perspectives proponents argue that accounting is not objective. Rather, the
accounting procedures and standards resulted from a complex web of economic,
political, and accidental co-occurrences. For example, the recent pronouncements
related to accounting for fair value and accounting for stock options created pressure
on Congress to interfere in the standard setting process. Similarly, the pronouncement
on loan impairments created outside pressures for the FASB to promulgate
accounting rules taking the present value of future cash flows into consideration. The
result is that debtors and creditors of impaired loans, in particular troubled debt
restructures, account for the same economic event in different ways. It is difficult to

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 explain how this kind of accounting asymmetry provides information that is
representationally faithful and therefore objective.

Critical perspectives proponents also argue that accounting has been unduly
influenced by utility based, marginalist economics. That is, the profit motive is all
that matters. This viewpoint overlooks many other goals of business organizations,
such as social goals. In addition, they argue that accountants aid profit oriented
groups to the detriment of others.

Critical perspectives proponents view organizations in both a historic and a societal

context. Accordingly, accounting should serve the good of society as well as
business organizations. It should concern itself with the powerful multinational
corporation and how these corporations affect the benefits received by and the costs
to society. For example, accounting reports should provide information regarding the
social costs of polluting the environment.

Team 2 Arguments supporting traditional mainstream accounting research

Traditional mainstream accounting research is concerned with unbiased, objective

reporting of results of economic transactions and events. Accounting serves a
stewardship function for investors, creditors and other users. Because the modern
corporation is characterized by separation of management and ownership, accounting
has a responsibility to owners to report how management has utilized the resources
entrusted to it and how the company has actually performed during the accounting
period.

Accounting does have a duty to society. But, that duty is not to try to cause
corporations to provide benefit to the society at large. Rather, in a free market
economy, business serves society by providing goods and services to the public. In
return, business provides a return to owners, jobs for societies people, and profits to
other businesses by buying goods and services from them. It is the accountant's job
to report on these activities so that users of accounting information can assess the
value of the company. It is not the accountant’s job to pass judgment on the activities
themselves or to bias reporting so that a societal goal can be reached.

Debate 4-3 Positive versus normative accounting theory

Team 1 Support reliance on positive theory to develop a general theory of accounting

Proponents of the positive theory of accounting maintain that it provides a

description of existing accounting practice. In fact, this theory has arisen because
existing theoretical constructs do not fully explain accounting practice. Stated
differently, positive theory explains what is, rather than what should be. Thus, it can
be used to explain why companies make the accounting choices that they do.

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 Positive accounting can be associated with the contractual view of the firm in which
accounting practices have evolved to mitigate contracting costs by establishing
agreement among varying parties. For example, a positivist would say that
conservatism has origins in the contract markets, including managerial compensation
contracts and lender debt contracts. To prove their point, one would argue that,
absent conservatism, managerial compensation agreements may reward managers
based on current performance that may later prove unwarranted.

According to Watts and Zimmerman, positive accounting theory should help us to

better understand the sources of pressures that drive the accounting standard-setting
process and how accounting standards affect individuals and individual behavior and
thus the allocation of resources. According to the theory, managers of firms make
accounting choices because of their own self interests. If we can better understand
how accounting standards affect management, then we can do a better job of writing
standards to help bring about appropriate, rather than dysfunctional management
behavior. If we don’t know how accounting standards will be used, then it is unlikely
that the goals of transparency and better reporting will be achieved.

Positive, not normative accounting theory, explains observed accounting practice.

Unlike normative accounting theory it does not rely on consensus of accounting
professionals. Because there is no set of goals that is universally accepted by
accountants, normative accounting theory development may not provide appropriate,
practical accounting standards. Thus, since normative accounting theories rely upon
acceptability, the resulting theoretical development may be suspect.

Team 2 Support reliance on normative theory to develop a general theory of accounting

Normative accounting theory is based on sets of goals which prescribe the way
financial reporting should be, not just how it is. If we do not know what we should
be reporting, how can we expect to develop accounting standards whose use will
produce financial reports that can be relied upon to present the true financial picture
of the reporting entity?

Accountants typically agree with the Conceptual Framework’s goal of providing

decision-relevant financial information to users. Decision-relevant financial reports
provide the user with information which they can use to predict future performance
and to compare companies. Only accounting standards that are based on what ought
to be are likely provide management with a consistent choice and application of
accounting policies so that reported results are unbiased and transparent. Accounting
standards derived from normative theory can result in financial statements that are
consistent across time and among companies. Knowledge of how managers can use
accounting information to bias financial results is useful, but does not provide
accountants with what they need to prepare decision-relevant financials.

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 Accounting standards should be based on clearly stated objectives that can be used to
derive logical and consistent principles and practices. Just because there is no
universally accepted set of objectives, does not mean that there should not be. There
is, at least, a relatively wide acceptance of the underlying objectives and assumptions
outlined in the FASB’s Conceptual Framework. These assumptions can certainly be
relied upon to aid in the development of logical and consistent accounting standards.
We can use these objectives and assumptions to logically derive accounting standards
using a deductive approach. In other words, deduction, based on agreed upon
assumptions, is an appropriate approach to accounting theory development. This is
the normative approach.

WWW

Case 4-10

a. Agency relationships involve costs to principals. Agency costs have been defined as
the sum of (1) monitoring expenditures incurred by principals to control the behavior
of agents, (2) bonding expenditures incurred by the agent, and (3) the residual loss.
Monitoring expenditures include such costs as costs of measuring and observing the
agent’s behavior and the costs of establishing compensation schemes that would tend
to provide incentives to the agent to realign personal goals to be closer to those of
principals. Bonding expenditures are incurred by the agent to guarantee that he will
not take certain actions to harm principal’s interest or that he will compensate the
principal if he does. The wealth effect caused by a difference between actions taken
by the agent and what the principal would have the agent take. Because individuals
are expected to take actions to maximize their own utility, managers and shareholders
are expected to incur monitoring and bonding costs as long as these costs are less
than the residual loss.

b. An increase in debt would increase agency costs. An increase in debt would increase
interest expense and lower income to stockholders. It would also increase the debt-
to-equity ratio and thus would be perceived as increasing risk. Increase in risk may
increase the cost of debt via increased interest rate.

c. To reduce risk, debt-holders often restrict the amount of debt a company can issue,
by putting a limit on the company’s debt-to-equity ratio. The debt covenants are a
bonding cost that reduce the cost of debt.

Case 4-11

The primary goal of accounting information is to provide investors with information that is
relevant and faithfully represents economic phenomena so they can make informed
investment decisions. Individual investors make the following investment decisions:

Buy—a potential investor decides to purchase a particular security on the basis of available
information.

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Hold—an actual investor decides to retain a particular security on the basis of available
information.
Sell—an actual investor decides to dispose of a particular security on the basis of available
information.

Individual investors use all available financial information to assist in acquiring or disposing
of the securities contained in their investment portfolios that are consistent with their risk
preferences and the expected returns offered by their investments. One of the methods
available to investors to make these decisions is fundamental analysis. Fundamental analysis
is an attempt to identify individual securities that are mispriced by reviewing all available
financial information. These data are then used to estimate the amount and timing of future
cash flows offered by investment opportunities and to incorporate the associated degree of
risk to arrive at an expected share price for a security. This discounted share price is then
compared to the current market price of the security, thereby allowing the investor to make
buy–hold–sell decisions.

Case 4-12

The students will have different answers to this case depending on the companies selected
and the time period chosen.

Financial Analysis Case

The students will have different answers to this case depending on the companies selected.

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