Accounting Theory

Session 6
Problem Set 10
Chapter 12
Standard Setting: Economic Issues

Adapted from Scott,

Financial Accounting Theory

Prof. Garen Markarian, PhD 1

 Problem Set 10
Question 1
1) An adverse selection problem can arise from information
asymmetry between issuer and buyer of securities.

Required:
a. Explain what the adverse selection problem is in this context.
b. How can financial accounting information reduce the adverse selection
problem?
c. Can financial accounting information eliminate the problem completely?
Explain.
d. What other ways operate to reduce the problem of inside information?

Prof. Garen Markarian, PhD 2

 Problem Set 10
Solution 1 a
1) Required:
a. Explain what the adverse selection problem is in this context.
People with valuable inside information about a firm may take advantage
of this information to earn profits at the expense of outside investors: they
may do this by failing to release their information or acting on it before
releasing it, then earning profits from insider trading.

Prof. Garen Markarian, PhD 3

 Problem Set 10
Solution 1 b
1) Required:
b. How can financial accounting information reduce the adverse selection
problem?
Financial accounting information can reduce the problem through:
• Full disclosure of useful information in the financial statements and notes.
• Supplementary disclosure such as MD&A.
• Timeliness of disclosure – full disclosure will reduce the scope for insider profits
to the extent the disclosure takes place soon after the inside information is
acquired.

Prof. Garen Markarian, PhD 4

 Problem Set 10
Solution 1 c
1) Required:
c. Can financial accounting information eliminate the problem completely?
Explain.
It is unlikely that financial accounting information can completely
eliminate the inside information problem: this would be too costly. For
example, some information is proprietary (R&D, merger and takeover
plans). Also, continuous disclosure of all useful information would be
necessary.

Prof. Garen Markarian, PhD 5

 Problem Set 10
Solution 1 d (1)
1) Required:
d. What other ways operate to reduce the problem of inside information?
Market forces may reduce the problem. If the issuer, or other insider, is
revealed to have engaged in insider trading or other abuse of inside
information, investors’ estimation risk will increase. The issuer’s cost of
capital will rise and reputation will be harmed, particularly if there is media
publicity.
Other forces derive from regulations, such as legal penalties, regulations
requiring information to be released to all parties simultaneously, and
requirements for firms to make immediate public announcements of
important events.

Prof. Garen Markarian, PhD 6

 Problem Set 10
Solution 1 d (2)
1) Required:
d. What other ways operate to reduce the problem of inside information?
Note: While not discussed in the text, many public companies have blackout periods
surrounding earnings announcement dates, during which employees are not allowed to
trade in company stock.

Prof. Garen Markarian, PhD 7

 Problem Set 10
Question 2
2) The failure of managers to release bad news is a version of the
adverse selection problem. Such failure indicates that the securities
market is not working well.

Required:
a. Why might a manager withhold bad news?
b. To what extent does the disclosure principle operate to reduce the incentive
of a manager to withholder bad news? Explain.

Prof. Garen Markarian, PhD 8

 Problem Set 10
Solution 2 a
2) Required:
a. Why might a manager withhold bad news?
Managers may withhold bad news to:
• Conceal evidence of shirking, if the bad news results from low manager effort.
• Delay a fall in share price, which would increase cost of capital and possibly
affect manager compensation.
• Enable insider trading profits.
• Postpone damage to reputation.

Prof. Garen Markarian, PhD 9

 Problem Set 10
Solution 2 b (1)
2) Required:
b. To what extent does the disclosure principle operate to reduce the incentive
of a manager to withholder bad news? Explain.
It will completely eliminate it if the following conditions hold:
• The information can be ranked from good to bad in terms of its implications for
firm value.
• Investors know that the manager has the information.
• There is no cost to the firm of releasing the information.
• Market forces and/or penalties ensure that the information released is truthful
(i.e.: credible).
• If the information affects variables used for contracting (e.g.: share price or
covenant ratios), release of the information does not impose increased
contracting costs on the firm.
Prof. Garen Markarian, PhD 10
 Problem Set 10
Solution 2 b (2)
2) Required:
b. To what extent does the disclosure principle operate to reduce the incentive
of a manager to withholder bad news? Explain.
Then, the market will interpret failure to disclose as indicating the worst
possible information. To avoid the resulting impact on share price, all but
the lowest-type manager will disclose.
If one or more of the above requirements is violated, the disclosure
principle may not completely eliminate the withholding of bad news.

Prof. Garen Markarian, PhD 11

 Problem Set 10
Solution 2 b (3)
2) Required:
b. To what extent does the disclosure principle operate to reduce the incentive
of a manager to withholder bad news? Explain.
This will be the case when (1):
• The information is proprietary. Then, there is a threshold level below which the
news will not be released (Verrecchia (1983)).
• If the market is not sure whether the manager has the information, there is a
threshold below which the news will not be released, even though it is non-
proprietary. The motivation to release non-proprietary information arises from its
effect on firm value (Pae, 2005).
• When GAAP quality is not too high, information that goes beyond mandated
information disclosure will only be disclosed voluntarily if it exceeds a threshold
(Einhorn, 2005).

Prof. Garen Markarian, PhD 12

 Problem Set 10
Solution 2 b (4)
2) Required:
b. To what extent does the disclosure principle operate to reduce the incentive
of a manager to withholder bad news? Explain.
This will be the case when (2):
• If release of information may trigger the entry of competitors, the firm may only
disclose a range within which the news lies. In this sense, disclosure is not
truthful (Newman and Sansing (1993)).
• If contracts, such as manager compensation, are based on share price and if
releasing the news will increase the firm’s contracting costs (e.g.: a forecast’s
effect on share price may swamp the ability of share price to reflect manager
effort), it may not be in the firm’s interests to release the information (Dye
(1985)).

Prof. Garen Markarian, PhD 13

 Problem Set 10
Solution 2 b (5)
2) Required:
b. To what extent does the disclosure principle operate to reduce the incentive
of a manager to withholder bad news? Explain.
We may conclude that while the disclosure principle has the potential to
motivate full release of bad news, in practice it is only partially effective
due to the number of scenarios where it breaks down.

Prof. Garen Markarian, PhD 14

 Problem Set 10
Question 3 (1)
3) On September 15, 2004, the Dow Jones Industrial Index suffered its
largest fall in a month, dropping by 0.8% or 86.8 points. The
Standard & Poor’s 100, 400 and 500 indices also dropped by similar
amounts.
According to media reports, the market declines were triggered by
Coca-Cola Co. and Xilnx Inc. (a large producer of computer logic
chips and related products). These companies announced that sales
and profits for the third quarter 2004 would be less than analysts’
estimates.

Prof. Garen Markarian, PhD 15

 Problem Set 10
Question 3 (2)
3) Required:
a. Why did the whole market decline?
b. What market failure does this episode illustrate? Explain why this is a
failure.

Prof. Garen Markarian, PhD 16

 Problem Set 10
Solution 3 a
3) Required:
a. Why did the whole market decline?
The market declined because the announcements of lower sales and profits
contained market-wide information. If sales and profits were lower for
these two large and diverse firms, this suggests that many other firms will
also suffer from reduced business activity. As investors bid down the share
prices of Coca-Cola and Xilinx (which in itself would lower the index), the
share prices of all other firms deemed to be affected by this reduced activity
also declined.

Prof. Garen Markarian, PhD 17

 Problem Set 10
Solution 3 b
3) Required:
b. What market failure does this episode illustrate? Explain why this is a
failure.
This episode illustrates the problem of externalities. The information
released by Coca-Cola and Xilinx about their own prospects also contained
implicit information about the prospects of other firms. The two companies
receive no reward for this economy-wide information, consequently there is
no incentive for them to release more than a minimum disclosure. For
example, perhaps more timely release, more information about why they
felt sales and profits will decline, having their auditors attest to the
information, and/or breaking the sales and profits down by company line of
business or division, would have helped the market to assess the extent to
which other companies would be affected.
Prof. Garen Markarian, PhD 18
 Problem Set 10
Question 4 (1)
4) In February 1998, Newbridge Networks Corp., a
telecommunications equipment maker based in Kanata, Ontario,
announced that its revenues and profits for the quarter ending on
February 1, 1998, would be substantially below analysts’ estimates.
Its share price immediately fell by 23% on the Toronto and New
York stock exchanges.
The sale, in December 1997, of over $5 million of the company’s
shares by an inside director of Newbridge was widely reported in
the financial media during February 1998. Details of sales by other
Newbridge insiders, including its CEO, during previous months
were also reported. The implication of these media reports was that
these persons had taken advantage of inside information about
disappointing sales of a new product line.
Prof. Garen Markarian, PhD 19
 Problem Set 10
Question 4 (2)
4) Required:
a. Which source of market failure is implied by these media reports?
b. What effects on investors, and on liquidity of trading in Newbridge shares,
would media reports of such insider sales be expected to create?
c. Suppose that Newbridge’s management felt that its share price was
undervalued by the market after the February earnings announcement.
Describe some signals that management and directors could engage in to
counter the public impression of lower-than-expected profitability.

Prof. Garen Markarian, PhD 20

 Problem Set 10
Solution 4 a
4) Required:
a. Which source of market failure is implied by these media reports?
The implied market failure is one of insider trading, a version of the
adverse selection problem.

Prof. Garen Markarian, PhD 21

 Problem Set 10
Solution 4 b (1)
4) Required:
b. What effects on investors, and on liquidity of trading in Newbridge shares,
would media reports of such insider sales be expected to create?
Investors will perceive greater estimation risk with respect to Newbridge.
The following effects would be expected (1):
• Some investors will withdraw from the market, since they feel that it is not a
level playing field, hence that there is little chance of earning a return on any
investments.
• Investors will bid down the price of Newbridge’s shares. The failure to meet
current earnings expectations will result in lower demand for its shares as
investors revise downwards their future earnings expectations. This effect will be
increased as investors realize the insider trading reveals inside information about
expectations of future profitability by Newbridge’s management.

Prof. Garen Markarian, PhD 22

 Problem Set 10
Solution 4 b (2)
4) Required:
b. What effects on investors, and on liquidity of trading in Newbridge shares,
would media reports of such insider sales be expected to create?
The following effects would be expected (2):
• The liquidity of trading in Newbridge’s shares will fall. This is due to two
effects. First, as investors depart the market for Newbridge’s shares, depth falls.
Second, the bid-ask spread rises as investors perceive greater information
asymmetry with respect to Newbridge insiders, due to a combination of unmet
earnings expectations and insider stock sales.

Prof. Garen Markarian, PhD 23

 Problem Set 10
Solution 4 c (1)
4) Required:
c. Suppose that Newbridge’s management felt that its share price was
undervalued by the market after the February earnings announcement.
Describe some signals that management and directors could engage in to
counter the public impression of lower-than-expected profitability.
Possible signals include (1):
• Raise private financing. Private capital suppliers will conduct due diligence
about future firm prospects before investing. This will signal Newbridge’s
willingness to subject itself to the investigations conducted by the lenders
without directly releasing proprietary information about future firm prospects.
• Issue public debt, as a signal that management believes that the probability of the
debtholders taking over the firm in the future is low.

Prof. Garen Markarian, PhD 24

 Problem Set 10
Solution 4 c (2)
4) Required:
c. Suppose that Newbridge’s management felt that its share price was
undervalued by the market after the February earnings announcement.
Describe some signals that management and directors could engage in to
counter the public impression of lower-than-expected profitability.
Possible signals include (2):
• Management could increase their shareholdings. This would, in effect, reverse
the earlier insider sales. Increased shareholdings would not be rational (i.e.: more
costly) if management was concerned about future firm performance.
• Engage a higher quality auditor, either by changing auditors or by extending the
scope of the existing audit.

Prof. Garen Markarian, PhD 25

 Problem Set 10
Solution 4 c (3)
4) Required:
c. Suppose that Newbridge’s management felt that its share price was
undervalued by the market after the February earnings announcement.
Describe some signals that management and directors could engage in to
counter the public impression of lower-than-expected profitability.
Possible signals include (3):
• Raise the dividend. This would not be rational if management was worried that
future earnings could not be sustained at a level to support the higher dividend.
• Adopt more conservative accounting policies. This will signal that future
earnings can stand resulting downwards pressure. It would not be rational to
adopt conservative policies if management believed this would decrease their
earnings-based bonuses or increase the probability of future covenant violation.

Prof. Garen Markarian, PhD 26

 Problem Set 10
Question 5 (1)
5) Imax. Corp. is a large entertainment technology company, with
headquarters in New York and Toronto, and theatres worldwide. Its
share price, which was as high as $13.89 on the Toronto Stock
Exchange in 2003, had fallen to a low of $5.50 following its
reporting of a loss, in accordance with U.S. GAAP, of $896’000 U.S.
for the first quarter of 2004. This compared with a profit of over
$2.4 million for the same quarter of 2003.
On May 14, 2004 (i.e.: after reporting the first quarter loss), The
Globe and Mail reported that a group of senior Imax executives had
bought about $1 million U.S. of Imax shares on the open market.

Prof. Garen Markarian, PhD 27

 Problem Set 10
Question 5 (2)
5) The company’s share price immediately rose by $1.17 to $7.20.
Imax later reported earnings for the second quarter of 2004 of
$1.552 million. However, its problems were not over. In March 2007,
the company announced that it was expanding a probe into its
accounting for the previous six years, following SEC and OSC
investigations into its revenue recognition practices. The company
also indicated that it had misclassified some expenses as capital.
Imax shares were threatened with delisting by NASDAQ, the
exchange on which its shares traded in the United States, since the
probe delayed the filing of its financial statements. The filing delay
also violated the covenants on its long-term debt. Imax shares fell by
over 6%, to $5.79, on the Toronto Stock Exchange on the day
following its announcement.
Prof. Garen Markarian, PhD 28
 Problem Set 10
Question 5 (3)
5) Required:
a. What apparent information was conveyed to the market by the executive
share purchase? Did the share repurchase constitute a credible signal at
the time? Explain why or why not.
b. What market failures are revealed by the subsequent probes into Imax’s
accounting policies? Explain.
c. Why would the Imax executives have brought shares when they must have
known about the opportunistic management of its reported earnings?

Prof. Garen Markarian, PhD 29

 Problem Set 10
Solution 5 a
5) Required:
a. What apparent information was conveyed to the market by the executive
share purchase? Did the share repurchase constitute a credible signal at
the time? Explain why or why not.
The executive share purchase conveyed favorable inside information about
the future prospects of the company.
Yes, the purchase constituted a credible signal, as evidenced by the strong
market response. Investors believed that it would not be rational for the
Imax executives to buy these shares unless they believed the company’s
future prospects were favorable.

Prof. Garen Markarian, PhD 30

 Problem Set 10
Solution 5 b
5) Required:
b. What market failures are revealed by the subsequent probes into Imax’s
accounting policies? Explain.
The market failures are adverse selection and moral hazard. It seems that
despite their 2004 share purchases, Imax managers adopted accounting
policies to overstate earnings, thereby compromising the interests of
debtholders and shareholders (adverse selection). By overstating earnings,
management may have also been attempting to cover up shirking (moral
hazard). These policies constitute market failures because information
about actual profitability was retained as inside information, resulting in the
overstatement of Imax share price for several years.

Prof. Garen Markarian, PhD 31

 Problem Set 10
Solution 5 c (1)
5) Required:
c. Why would the Imax executives have brought shares when they must have
known about the opportunistic management of its reported earnings?
Reasons why management bought shares (1):
• They may have felt that Imax shares were undervalued by the market in 2004.
The earnings management that took place during this time could be interpreted
as an attempt to report what management felt was Imax’s persistent earning
power.
• Management may have been low type (i.e.: they expected that future firm
prospects were unfavorable) but were willing to pay the extra cost to signal high
type. Perhaps they had plans to sell the shares later as share price rose due to the
earnings management and consequent higher reported profits. Perhaps higher
share price would increase their compensation.

Prof. Garen Markarian, PhD 32

 Problem Set 10
Solution 5 c (2)
5) Required:
c. Why would the Imax executives have brought shares when they must have
known about the opportunistic management of its reported earnings?
Reasons why management bought shares (2):
• Management may have wanted to increase its motivation to work hard, to pull
the firm out of deteriorating operating performance. Increased share holdings
would supply additional motivation.

Prof. Garen Markarian, PhD 33