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Chapter 3 Overview of Accounting Analysis

Discussion Questions 1 & 6 1. A financ financee student student states, ! don"t don"t understand understand why why anyone anyone pays any attention to accounting earnings nu#$ers, given that a %clean" nu#$er lie cash fro# operations is readily availa$le.' Do you agree( )hy or why not(

There are several reasons why we should pay attention to accounting earnings numbers. First, net income predicts a company’s future future cash flow  better than current cash flow does. Net income aids in predicting future cash flows by reporting transactions with cash consequences at the time when the transactions occur, rather than when the cash is received or paid. Net income is computed on the basis of expected, not necessarily actual, cash receipts and payments. Second, net income is potentially informative when there is information asymmetry between corporate managers and outside investors. Note that corporate managers with superior information choose accounting methods and accrual estimates which determine the net income number. ecause accrual accounting requires managers to record past events and to ma!e forecasts of future effects of these events, net income can be used to convey managers’ superior information. For example, a company’s decision to capitali"e some portion of current expenditure, which increases today’s net income, conveys potentially informative signals to outside investors about the company’s ability to generate future cash flows to cover the capitali"ed costs.

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6. *he conservatis# principle arises $ecause of concerns a$out #anage#ent"s incentives to overstate the fir#"s perfor#ance. +oe ans argues, )e could get rid of conservatis# and #ae accounting nu#$ers #ore useful if we delegated financial reporting to independent auditors rather than to corporate #anagers.' Do you agree( )hy or why not(

$e don"t agree with %oe an!s because the delegation of accounting decisions to auditors may reduce the quality of financial reporting. &uditors  possess less information and firm'specific business !nowledge than corporate managers when portraying the economic reality of a firm. The divergence between managers’ and auditors’ business assessments is li!ely to be most severe for firms with distinctive business strategies or ones which operate in emerging industries. $ith such an information disadvantage, even if auditors report truthfully without having any incentive  problem, they cannot necessarily choose (better) accounting methods and accruals than corporate managers do. &uditors also have their own incentive to record business transactions in a mechanical way, rather than using their professional *udgment, which leads to poor quality of financing reporting. For example, auditors are li!ely to choose accounting standards that require them to exercise minimum  business *udgment in assessing a transaction’s economic consequences, especially given their legal liability ris!. The current debate on mar!et value accounting for financial institutions illustrates this point. $hile there is considerable agreement that mar!et value accounting produces relevant information, auditors typically oppose it, citing concerns over audit liability.

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