Type:
Solution Manual
Resource:
Intermediate Accounting, Vol. 1
Edition:
4th Edition
Author(s):
Kin Lo George Fisher
INSTRUCTOR’S SOLUTIONS MANUAL Intermediate Accounting Volume 1 Fourth Edition Kin Lo
University of British Columbia
George Fisher Douglas College
Chapter 1 Fundamentals of Financial Accounting Theory I. Problems P1-1. Suggested solution: People need to make decisions under uncertainty, which creates the demand for information to reduce that uncertainty, allowing them to make better decisions. However, if everyone had access to the same information at the same time, no one would be able to supply any information useful to anyone else (since they already have it). Thus, an asymmetric distribution of information is necessary for the supply of information from those who have relatively more of it to those who have relatively less. P1-2. Suggested solution: An IPO is a sale of a part of the entrepreneur’s company to other investors. Inherently, there is uncertainty about the future success of this company and the value of the company’s shares in the future. Potential investors demand information to reduce this uncertainty. If the entrepreneur is able to supply information that reduces the potential investor’s perceptions of uncertainty, she is likely to be able to obtain a higher stock price in the IPO. The entrepreneur has intimate knowledge of her company’s operations, which is likely to be far superior to the information available to potential buyers of the IPO shares—there is information asymmetry between the entrepreneur and potential investors. P1-3. Suggested solution: A borrowing/lending transaction involves an advance of funds from the bank to the company in exchange for promises of future repayment from the company to the bank. There is, of course, uncertainty regarding the ability of the company to repay the bank in the future. The corporation’s management has better information about the company’s prospects in comparison to bank staff. To reduce this information asymmetry, the bank demands information such as audited financial statements. The corporation is willing to supply this information in order to obtain the most favourable borrowing terms (e.g., a low interest rate).
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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fourth Edition
P1-4. Suggested solution: Hidden action or information? Information about past, present, or future? Associated with the market for “lemons” or insurance deductibles? Mitigation of information asymmetry involves risk sharing or full disclosure? Most closely associated with investment decisions or compliance with contractual terms? Creates demand for provision of relevant or reliable information?
Adverse selection Hidden information Past and present Market for lemons
Moral hazard Hidden action Future Insurance deductibles
Full disclosure
Risk sharing
Investment decisions
Compliance with contractual terms
Relevant information
Reliable information
P1-5. Suggested solution: The managers within companies have an information advantage over outside investors. This adverse selection causes investors to be sceptical of investing in the company, unless management provides information to alleviate that scepticism. If management withholds information, investors will rationally price the company as a “lemon.” To avoid this negative outcome, management’s best response is to voluntarily provide information to investors. P1-6. Suggested solution: Signalling must be costly to be credible because a costless signal can be sent by anyone. A signal that can be sent by anyone has no value because such “cheap talk” does not help differentiate one party from another. Thus, the signal should not believed—it is not credible. Since signalling must be costly to be credible, a company that can credibly communicate information through other more cost effective means would avoid costly signalling. Therefore, if there are no other cost effective means to communicate a particular type of information, the company could choose to use costly signalling. For example, to credibly indicate management’s belief in the sustainability of the company’s cash flows, the company can commit to a higher level of dividend payments to shareholders. P1-7. Suggested solution: The separation of ownership and management creates a moral hazard by allowing management to take responsibility for the resources of shareholders, and the shareholders cannot monitor management. Shareholders would like to see high returns on their investment, but this can only be expected if management works hard to create value. Managers incur the cost of hard work, but they do not obtain the benefits of that hard work in the absence of incentive pay. Accounting information helps to alleviate this moral hazard in two ways. Accounting reports provide measures of performance that shareholders can use to evaluate/monitor management. Second, the accounting performance measures can be used as a basis for rewarding
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Chapter 1: Fundamentals of Financial Accounting Theory
management. Incentive pay linking management compensation to value creation helps to align the interests of management with those of shareholders. P1-8. Suggested solution: Moral hazard arises in a lending context because the bank loses control of funds that it advances to the borrowing enterprise. The bank is justifiably worried that the borrower will misspend the funds and not repay the loan and interest. This scepticism causes banks to be reluctant in lending and to charge high interest rates to cover potential losses from unpaid loans. Accounting information can be valuable in alleviating this moral hazard by allowing the bank to monitor the performance of the borrower using the accounting reports (e.g., is the company profitable, how much assets does it have, how much cash flow is it generating?). Part of the monitoring is in the form of covenants that require the company to comply with various financial ratios computed using accounting reports. By alleviating the extent of moral hazard, accounting information allow banks to be less sceptical of borrowers and thereby lower the interest rates that they charge and increase their lending activity. P1-9. Suggested solution: An agency problem (moral hazard) arises when shareholders hire a manager to run the business for them, as the shareholders cannot directly observe management’s actions in administering the resources entrusted to him. Some would suggest that the shareholders’ motivation for investing is solely to maximize their returns while the employee’s (management) motivation for working is to do as little as possible to earn the agreed upon salary. While this is likely an extreme case it remains that shareholders are normally interested in earning high returns whereas the manager may be reluctant to work hard to create those returns unless there is an incentive to do so. There are various ways to mitigate this problem, including: Linking the manager’s pay to value creation by paying a bonus for achieving stipulated financial targets such as net income, return on equity, and sales growth. Granting the manager a partial ownership interest in the company though direct shareholdings or a stock option plan so as to align the manager’s interests with that of the owners. Using accounting reports to monitor the company’s performance as a proxy (indirect measure) of the manager’s performance. P1-10. Suggested solution: This is a case of adverse selection, because the information is not affected by the actions of the person who has the information—we cannot change time. There is only hidden information, not hidden actions. (Using a fake or borrowed piece of identification is fraudulent and the insurance would be voided.) P1-11. Suggested solution:
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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fourth Edition
All three situations are most likely cases of moral hazard as they involve hidden actions, rather than hidden information. An outcome of moral hazard is that parties may take on risks because the negative consequences of those risks will be borne by someone else. In situation (a) the mortgage company earns the commission for making the loan but it is the investors who purchase the pool of mortgages that lose money when the unqualified borrowers default. The hidden action is not verifying the applicants’ income. In situation (b) your friend enjoys his consumer purchases while knowing that he will not have to repay the additional debt when he seeks bankruptcy protection. The hidden action is not telling the credit card companies that he intends to file for bankruptcy at the end of the month. In situation (c) you have little incentive to protect your home as the insurance company bears the risk for loss or damage. The hidden action is not using your alarm system. P1-12. Suggested solution: Version A of the game involves only uncertainty; the information is symmetrically distributed among all three participants in the game. While there is a demand for information about the value of the drawn card, there is no information for anyone to supply to anyone else. In this scenario (and assuming “risk neutrality”), the rational bids start at $1 and go no higher than $5.50, the latter being the expected value of the card. Bids higher than $5.50 will lose money on average. While the lowest bid of $1 provides you with the most profit, competition from Julia forces you to successively increase your bid, so we expect the equilibrium final bid to be $5.50. Version B of the game involves both uncertainty and information asymmetry. Scott has more information than you and Julia, so he can supply you with information if it is in his best interest to do so. In this game, your best strategy is to bid $1 and to make higher bids only if Scott provides information that indicates the card has a higher value. Since Scott’s income depends on how much you and Julia bid, and his cost equals the value of the card, it is in his interest to provide as much information as possible so that the bids are as high as possible. (Scott’s disclosures about the card must be truthful because they can be verified against the card at the end of the game.) For example, if the card is a seven of hearts, Scott can say any of the following: “the card has hearts,” which is true but not useful; “the card is higher than three,” which is true; “the card is at least six,” which is also true. Since you and Julia increase your bids according to the information that Scott provides, ultimately he is forced to say something that reveals the card’s value of seven. This is the full-disclosure outcome in adverse selection. There is no moral hazard because there is nothing that Scott can do to change the value of the card that was drawn. P1-13. Suggested solution: * *
This scenario is an example of an agency relationship that gives rise to moral hazard. The taxi driver is an agent of the taxi company. . 1-4
Chapter 1: Fundamentals of Financial Accounting Theory
* * *
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The driver has an information advantage over you (the passengers/visitors) regarding the geography of the city. The driver also has an information advantage over the management and owners of the taxi company regarding the minute-to-minute operations of the taxi. The fare meter is a device to mitigate these two information asymmetries. It is an indirect monitoring device for the taxi company to track how the taxi driver is operating the taxi. It also provides incentives for the driver to take passengers using an efficient route. (Note that the fare increases for both distance travelled and time, so there is more reward when the taxi is moving rather than idling, and more reward when it moves faster.) An assumption we take for granted, but which is nonetheless important, is that the driver’s pay is directly linked to the taxi fare. The meter does not eliminate moral hazard problems. It is only an indirect monitor of driver behaviour and tracks a limited number of items. If the driver is unfriendly or drives recklessly, the meter would not capture that information. The metered fare also does not preclude a driver taking a circuitous route to increase the distance travelled and thus increasing the fare. Many cities require taxi cabs to post estimated fares from the airport to popular destinations such as downtown so that taxi drivers do not take advantage of visitors who are not familiar with the city’s geography. Providing a gratuity at the end of the trip is a separate practice that helps to mitigate the moral hazard problem: the passengers serve as the monitors of the driver’s behaviour. For the meter system to be useful, the taxi company and passengers must be confident of its reliability. A meter that can be easily tampered with by the driver will provide misleading information to these users.
P1-14 Suggested solution:
First note that, without genetic tests, individuals and insurance providers have the same (lack of) information. Insurers are willing to provide coverage to individuals because they can spread the risk over many individuals. They only need to be right on average for the insurance premiums they collect to be sufficient to cover the medical costs when they arise. This is a case of adverse selection (not moral hazard) because genetics cannot be changed; it is just a matter of individuals having an information advantage over the insurance companies. With the advance in genetic testing, individuals will have a better understanding of which medical conditions they are more likely to experience. Under GINA, insurance providers will suspect that individuals will have genetic tests results that are not accessible to the insurance company. Individuals who know that they have a genetic pre-disposition to certain ailments will seek insurance for those conditions, and the insurance company cannot prevent them from doing so under GINA. Other people who do not have these genetic pre-dispositions will find less benefit to obtaining this insurance. Thus, the expected cost of insurance will increase. To cover that increased cost, insurance companies will need to raise insurance premiums. The increased premiums will further reduce the pool of people who will find the insurance beneficial. Hence, the reference to adverse selection spiralling out of control. . 1-5