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Instructor’s Manual—Chapter 6

Copyright © 2009 Pearson Education Canada 161

CHAPTER 6

The Measurement Approach to Decision Usefulness

6.1 Overview

6.2 Are Securities Markets Fully Efficient?

6.2.1 Introduction

6.2.2 Prospect Theory

6.2.3 Is Beta Dead?

6.2.4 Excess Stock Market Volatility

6.2.5 Stock Market Bubbles

6.2.6 Efficient Securities Market Anomalies

6.2.7 Implications of Securities Market Inefficiency for Financial Reporting

6.2.8 Discussion of Market Efficiency v. Behavioural Finance

6.2.9 Conclusions About Securities Market Efficiency

6.3 Other Reasons Supporting a Measurement Approach

6.4 The Value Relevance of Financial Statement Information

6.5 Ohlson’s Clean Surplus Theory

6.5.1 Three Formulae for Firm Value

6.5.2 Earnings Persistence

6.5.3 Estimating Firm Value



6.5.4 Empirical Studies of the Clean Surplus Model

6.5.5 Summary

6.6 Auditors’ Legal Liability

6.7 Asymmetry of Investor Losses

6.8 Conclusions on the Measurement Approach to Decision Usefulness

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES

1. To Understand the Measurement Perspective on Financial Reporting

I begin coverage of this chapter by engaging the class in a discussion of what the

measurement perspective means. Points that I bring out are as follows:

(i) Review the information perspective, which, by and large, is oriented to

historical cost-based accounting supplemented by additional disclosure to bring

out measurement aspects. This perspective, drawing on the implications set out

by Beaver (1973) (see Section 4.3), relies on efficient securities market theory to

assume that additional supplemental disclosure in financial statement notes,

MD&A, and elsewhere will be fully digested by the market. This rationalizes the

retention of historical cost-based valuations in the financial statements proper.

(ii) Review the concept of current value. See Section 1.2 for definition. As

pointed out in that chapter, there are two approaches to current value—value-in-

use and fair value. Further discussion of the FASB’s approach to fair value

(SFAS 157) is deferred to Section 7.1.

(iii) Tie both current value approaches to the concept of decision usefulness.

That is, given the ample evidence that historical-cost-based net income has

information content for investors, why try to "fix" historical cost accounting if it

"ain't broken"? An answer is that perhaps decision usefulness can be further

increased by building more current values into the financial statements proper,



hence into the measurement of net income. The focus of this chapter is to

explore why accountants are moving towards a measurement approach.

(iv) Don't forget about reliability. If the measurement perspective is to enhance

decision usefulness, there must not be a significant reduction in reliability.

Reliability appears to have been a problem with RRA, for example, and for many

of the cases of premature recognition referred to in Chapter 2 (see Problems 12,

22, and 23). I sometimes tie this argument back to the information system (Table

3.2). That is, the ability of accounting information to predict future firm

performance will only be enhanced if increased relevance under the

measurement perspective is not cancelled by reduced reliability, relative to

historical-cost-based information. It is the net effect on the main diagonal

probabilities of the information system that will govern whether or not fair value

accounting increases decision usefulness.

2. To Appreciate Reasons Why Financial Reporting is Moving in a Measurement Direction

The text suggests four reasons why financial reporting is moving in a measurement

direction. These are:

(i) Theory and evidence that securities markets may not be as fully efficient

as the information perspective assumes. Then, building more current values into

the financial statements proper may enable the market to better predict future

firm performance. This, of course, is because current values are more relevant

than historical costs, and, by definition, relevance is the ability to predict future

economic performance.

(ii) Low value relevance of financial statement information. This is Lev’s

(1989) “low R2” argument. Perhaps the apparent decline in the proportion of

abnormal share price variability explained by unexpected earnings can be

reversed by introducing more current values into the measurement of net

income.



(iii) Ohlson’s clean surplus theory. This theory demonstrates that,

theoretically, firm value can be derived from financial statement information just

as well as from dividends or cash flows. The derivation starts with balance sheet

net worth and adds discounted expected future abnormal earnings. To the extent

that the balance sheet is based on current values, there are less future abnormal

earnings to predict, since, by definition, current value incorporates expected

future value, either by market value or value-in-use. Thus, other things equal, the

better the balance sheet incorporates current values, the better the predictions of

firm value. This argument assumes that the balance sheet current values are

reasonably reliable. More fundamentally, the demonstration of the equivalence of

dividend, cash flow and financial statement-based approaches to firm valuation

puts earnings prediction on a firm theoretical basis, leading naturally to a

measurement perspective.

(iv) Auditor liability. My own view is that much of the pressure for more

measurement in the financial statements proper arises from auditor liability,

particularly with respect to the failures of financial institutions in the United States

during the 1980s. This may explain why the SEC, for example, has pushed for

current value accounting. Perhaps greater use of current values in the accounts

will better enable the market to anticipate financial distress, thereby reducing the

number of auditor lawsuits.

I have gone out on a bit of a limb in suggesting these reasons for increased attention by

accountants to measurement issues, since they are speculative on my part. Instructors

are urged to challenge them if they do not agree. Certainly, as will be documented in

Chapter 7, accounting practice is moving in a measurement direction. The interesting

question is why.

In view of the downturn in economic activity in the early 2000s, and numerous highly-

publicized major business failures, instructors may wish to discuss whether the

movement to a measurement approach will be inhibited or enhanced (see the brief

discussion at the end of Section 7.6). On the one hand, we have seen major ceiling test

writeoffs, which emphasize how quickly fair values can change (for example, JDS

Uniphase wrote off $50 billion of assets in its 2001 fiscal year—see the Theory in



Practice vignette 7.3 in Section 7.4.2 and related discussion.). Also, failures of firms like

Enron Corp. (Section 1.2) have drawn attention to accounting failures, some of which

may involve current value accounting. For example, some of Enron’s overstated

earnings arose from its share of the gains resulting from fair-valuing financial

instruments, including Enron’s own stock, held by its unconsolidated, off-balance sheet

special-purpose partnerships. Perhaps one of the lessons to be learned from these

events is that value is fleeting, and that historical cost provides a more reliable basis of

accounting. A similar lesson was learned following the great stock market crash of 1929

(see Section 1.2).

On the other hand, recent events may enhance the use of current value accounting.

The rash of major business failures may underline the role of fair value accounting in

helping the market to anticipate financial distress.

3. To Review Theory and Evidence that Securities Markets May Not be Fully Efficient.

To this point, the text has accepted securities market efficiency. Indeed, it concludes in

Section 5.4.4 that the evidence of securities market response to financial statement

information supports efficient market theory and the decision theory that underlies it.

Yet, theory and evidence from behavioural finance questioning market efficiency has

accumulated to the point where it cannot be ignored.

In Section 6.2.9, I conclude that securities markets are not fully efficient. However, I

argue that whether securities markets are or are not fully efficient is not the right

question. Rather, the question is one of the extent of efficiency. I conclude that, despite

the evidence from behavioural finance, markets are close enough to being efficient that

the theory is still the most useful one upon which to base an analysis of the usefulness

of financial statements for investment decision making.

However, I also conclude that the rational investor model, outlined in Chapter 3 can

explain efficient market anomalies just as well as behavioural models, when one takes

into account the costs of fully analyzing all available information and recognizes that

underlying firm parameters such as earning power are not stationary. But, regardless of

the forces that drive market inefficiency, the implications for financial reporting are the



same, namely, better measurement will reduce market inefficiencies. Thus, market

inefficiencies can only increase the role of financial statements in informing investors.

I do not spend much class time on the material in Section 6.2, since the section is

designed to be self-contained. My main concern is that the students understand my

conclusions that securities market inefficiency does not invalidate the economics and

market-oriented approach to financial reporting in this book (of course, they may

understand it but not accept it!). For the time I do spend, I usually choose one of the

financial statement anomalies in Section 6.2.6. The prospect of “beating the market,”

which is a common approach to demonstrating a departure from full efficiency, appeals

to most students. I find the Sloan (1996) study of market response to accruals to be

useful in this regard since it introduces the distinction between operating cash flows and

accruals, a distinction which becomes quite important in Chapters 8 and 11.

However, instructors who are less enamoured with securities market efficiency and

decision theory can use Section 6.2 as a “launching pad” for a more in-depth study of

the behavioural roots of inefficiency. The various readings referenced in the section are

intended to be useful in this regard.

4. To Introduce Ohlson's Clean Surplus Theory

I usually confine my presentation to illustrating how the theory can be used to estimate

firm value, following the development in Section 6.5.3 for Canadian Tire Corp., or some

other well-known firm. On the way through my illustration, however, I bring out relevant

aspects of the theory. The following are the major points I bring out.

(i) I treat this theory as providing a demonstration of how firm value can be

expressed in terms of financial statement variables, consistent with the

measurement perspective. The theory is based on dividends as the fundamental

determinant of firm value. Given arbitrage, dividend irrelevance, and risk neutral

firm valuation, firm value is also determined by the value of the firm's net balance

sheet assets plus the expected present value of its future abnormal earnings

(i.e., its goodwill). This is because the value of the firm's net balance sheet

assets captures the present value of its future "normal" earnings, and sooner or

later all earnings – normal plus abnormal – will be paid out as dividends.



(ii) A fundamental significance of the clean surplus theory is that it roots

financial accounting theory solidly in the theory of value. Instead of having to

borrow theories from economics and finance, financial accounting itself contains

a theoretically sound valuation benchmark. In this sense, the theory plays a role

analogous to the Modigliani-Miller theory in finance.

(iii) Under the simplest version of clean surplus theory (unbiased accounting

and no earnings persistence) the expected present value of future abnormal

earnings is zero and, with no persistence of abnormal earnings, the value of the

firm is read directly from the balance sheet, as in Example 2.2.

(iv) How do earnings enter into the theory? Given the wealth of evidence in

Chapter 5 that the securities market responds to earnings, the theory seems

incomplete if earnings play no valuation role. When accounting is unbiased, they

do not play a role, since all value appears on the balance sheet (i.e., unrecorded

goodwill is zero) However, when earnings lag real economic performance (biased

accounting), expected abnormal earnings are the basis for estimating unrecorded

goodwill. This is illustrated in the latter part of Section 6.5.1 by assuming the firm

uses straight line, rather than economic, amortization.

When applied to a real firm, the firm’s actual share price is usually (but not always)

greater than the clean surplus estimate. The text goes into considerable soul-searching

at this point. The main point to bring out is the assumption in Section 6.5.3 that

Canadian Tire’s abnormal earnings will continue at their present rate for seven years

and then fall to zero. Obviously, a variety of other assumptions can be made, as

discussed in the text. The important point, however, is that prediction of future earnings

is the most critical aspect of the application of the theory to valuation. The persistence

of abnormal earnings ultimately depends on how successful the firm is in staving off the

competition that is inevitably attracted to the presence of abnormal earnings. The

answer ultimately depends on the firm’s business strategy, a topic beyond the scope of

this text.

For instructors who wish to pursue clean surplus theory in greater depth, Section 6.5.2

gives a simplified version of the Feltham and Ohlson earnings dynamic. The



persistence parameter ω of the earnings dynamic specifies a linkage between current

and future abnormal earnings. Thus, according to the theory, the market looks to the

income statement for the current realization of abnormal earnings, consistent with the

empirical evidence of the impact of earnings on share price given in Chapter 5.

If the accounting is biased, as under the historical-cost basis, the income statement

assumes still greater relevance since it then also indicates how much of the downward

bias of bvt is realized in the current period. The parameter νt-1 captures the impact on

future earnings of events in year t-1 that are not recognized in net income of year t-1.

The downward bias in earnings resulting from the expensing of R&D is discussed in

Section 6.5.3 of the text. Other examples of how additional information can be used to

refine estimates of future earnings are discussed in Section 6.5.4. See Abarbanell and

Bushee (1997) re “fundamental signals” from the balance sheet, and Begley and

Feltham (2001) re capital expenditures.

Note that earnings can be predicted using analysts’ forecasts, instead of by means of

the earnings dynamic. This is discussed in Section 6.5.3. For instructors who wish to dig

more deeply into the use of the earnings dynamic versus analysts’ forecasts in

predicting earnings, see the papers of Dechow, Hutton and Sloan (1999) referenced in

Section 6.5.3. and Courteau, Kao and Richardson (2001) referenced in Section 6.5.4.

Most students find an assignment requiring them to use the clean surplus model to

estimate firm value and compare with actual share price to be quite interesting. The

Canadian Tire example in Section 6.5.3 provides a template. Also, two excellent cases

that use the theory to predict firm value have been prepared by Professor Charles Lee.

These are:

The Timberland Company

Echlin Inc.

c. 1994, Cases in Financial Statements Analysis, Michigan Business School. See also

C.M.C. Lee, “Measuring Wealth,” in CA Magazine (April, 1996), pp. 32-37, which

includes Timberland.



The thrust of these cases is to demonstrate that firm valuation based on

Edwards/Bell/Ohlson (EBO), which is the term they use for clean surplus theory, is

easier and conceptually similar to a discounted cash flow approach to firm valuation.

The Canadian Tire example in the text is based on the procedure outlined in Lee.

Instructors who assign this valuation exercise can save numerous e-mails from students

who cannot find the beta of their chosen firm (needed to estimate cost of capital using

CAPM) by providing sources of beta up front. Currently, the finance section of major

websites, such as Yahoo.com and reuters.com provide a free source, including for TSX

firms. Unfortunately, however, betas for many firms are not reported. When this

happens, I advise students to either change firms or to calculate beta themselves from

first principles, using about 30 days of recent firm and market returns data. Calculation

of beta is explained in Section 3.7.1.

Students also have problems in estimating the expected return on the market, another

input into CAPM, especially if the previous year’s market return is negative. While not

mentioned in the text, the concept of market risk premium, that is, the extra return over

the risk free rate demanded by the market to invest in risky equities, provides a way to

estimate the expected return on the market. For a brief outline of how to apply the

market risk premium in a CAPM context see Bernard, Healy and Palepu, Business

Analysis and Valuation, second edition (Cincinnati, Ohio: South-Western College

Publishing, 2000), pp. 12-14 to 12-16.

If further motivation of clean surplus theory is desired, its close equivalence to EVA can

be pointed out. For this purpose, I use Problem 10 of this chapter, from Domtar Inc.’s

1996 Annual Report. I have not been able to find a more recent disclosure of EVA in

Domtar annual reports, although I believe, despite the lack of reference in its 2006

annual report, the firm still uses EVA internally. Another EVA reference is “Valuing

companies, A star to sail by?” The Economist (August 2, 1997), pp.53-55. This article

discusses some of the criticisms of EVA.



5. To Demonstrate How Asymmetry of Investor Losses from Financial Statement Over- or Under- Valuations Contributes to Auditor Liability and Conservatism

This section is largely optional reading. However, it illustrates my conviction that the

main reason for conservative accounting is that risk-averse investors who rely on

financial statement information for consumption/investment decisions suffer greater loss

of utility from an overstatement of firm net assets than for an equal amount of

understatement. Thus, a downwardly biased (i.e., conservative) valuation of net assets

leads to greater investor expected utility than an unbiased (i.e., current value) valuation.

Downwardly-biased valuations thus contribute to reducing auditor liability because

downward biasing reduces the likelihood that there will be an overstatement error, and it

is overstatement errors, rather than understatements that usually lead to lawsuits

against auditors.

This argument is demonstrated using an elaboration of the single-person decision

theory illustrated in Section 3.3. In the process, the distinction between conditional and

unconditional conservatism is brought out.



SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS

1. The following reasons for a measurement approach are suggested:

• It appears that historical cost-based net income explains only about 2–5%

of the variability of share prices around the time of earnings

announcement. This is Lev's (1989) "low R2" argument. Introducing more

value-relevant information into the financial statements proper may

increase earnings quality, assuming reasonable reliability, and thus

increase the "market share" of net income.

• Evidence of efficient securities market anomalies suggests that investors

need more help in interpreting supplemental disclosure than the

information perspective has assumed. Incorporating more value-relevant

information into the financial statements proper may be a way to do this.

• Perhaps the introduction of more value-relevant information into the

financial statements will reduce auditors' legal liability, since the auditors

can then better argue that the financial statements anticipated the

changes in value that led to legal liability. This is particularly the case for

overstatements of value. Overstatements can be reduced by conservative

accounting in the financial statements proper, such as ceiling tests.

• Ohlson's clean surplus theory provides a theoretical framework supportive

of a measurement perspective.

2. Adoption of a measurement approach will increase the relevance of financial

statement information. Relevant information is information that enables users to

evaluate the firm’s future performance. The measurement approach implies the

use of current values of assets and liabilities, such as market values (market

price today is the best estimate of value tomorrow). Consequently, this

perspective is more relevant than valuations based on historical cost.



Assuming that well-working markets are available, a measurement approach

should not reduce reliability. Market values are representationally faithful since a

well-working market value represents the real value of the item being valued.

Also, market values are difficult for managers to bias and are verifiable.

However, if well-working market values are not available, estimates of fair value

must be made, and such estimates imply lower reliability.

The effect of the measurement perspective on decision usefulness thus depends

on its relative effects on relevance and reliability. If the main diagonal

probabilities of the information system increase due to higher relevance by more

than they decrease due to lower reliability, decision usefulness of the financial

statements proper will increase.

3. Post-announcement drift is the tendency for the share prices of firms that report

GN or BN in quarterly earnings to drift upwards and downwards, respectively, for

a lengthy period of time following the release of the earnings report.

It is known that quarterly seasonal earnings changes are positively correlated.

The reporting of, say, GN this quarter (compared with the same quarter last year)

increases the probability of reporting GN next quarter as well. Thus, current

quarterly earnings have two components of information content. One component

is their information content per se—they provide current GN or BN that enables

investors to revise their beliefs about future firm performance. Second, they

increase the probability of GN or BN in future quarters, which will enable a further

belief revision.

This is an anomaly for efficient securities markets theory because, to the extent

that the drift is not explained by barriers to arbitrage such as idiosyncratic risk or

transactions costs, share prices should respond immediately to all the

information content of earnings, according to the theory. However, this does not

seem to happen. Instead, the market takes a lengthy period of time to figure this

out or, alternatively, it waits until the current implications are validated in

subsequent quarterly reports.



Post announcement drift may or may not imply non-rational investors. On the one

hand, it could be driven by behavioural biases such as conservatism or limited

attention. On the other hand, it could be driven by the uncertainty of rational

investors about whether the firm’s expected earning power has in fact increased

(for GN) or decreased (for BN). In the face of this uncertainty, investors attach

some probability to each possibility, and revise their probabilities over time as

new evidence appears. These revisions will produce an upward or downward drift

in share price over time.

4. The efficient market will respond more strongly to the GN or BN in earnings (i.e.,

a higher ERC) the greater is the persistence of the GN or BN. Cash flows are

more persistent than accruals since the effects of accruals on current earnings

reverse in future periods, whereas (operating) cash flows are not subject to this

reversal phenomenon. Sloan checked this argument for his sample firms and

found that cash flows were indeed more persistent than accruals.

This being the case, the efficient market will respond more strongly to a dollar of

abnormal earnings if it comes from operating cash flows than if it comes from

accruals (recall that net income equals operating cash flows plus or minus net

accruals). Sloan found that while the market did respond to the GN or BN in

earnings, it did not respond more strongly when there was a greater proportion of

cash flows to accruals in earnings. This is an anomaly because a differential

response is predicted by efficient securities market theory.

5. According to rational single-person decision theory, the investor will prefer the

first fund, since it has both a higher expected return and a lower risk.

According to prospect theory, however, investors will separately evaluate gains

and losses on their investment prospects, and the rate of decrease of utility for

small losses may be considerably greater than the rate of increase of utility from

small gains. Since the second fund truncates the fund losses, this gives it an

advantage over the first fund.

Also, under prospect theory, investors may underweight probabilities of states

that are likely to happen, as a result of overconfidence bias, and overweight



probabilities of states that are unlikely to happen, due to representativeness bias.

The probability of a gain (a state realization) on the first fund is high relative to

the probability of a gain on the second fund (due to higher expected return and

lower standard deviation of the first fund. Thus, underweighting the high

probability of a gain on the first fund and overweighting the low probability of a

gain on the second fund tilts the decision towards the second fund.

Thus, the choice of the second fund is due to either or both of a relatively high

disutility for losses and weighting of probabilities.

6. a. Earnings quality, also called informativeness of the information system, is

the ability of current earnings to enable investors to infer future firm performance.

It can be conceptualized by the main diagonal probabilities of the information

system (Table 3-2). The higher the main diagonal probabilities relative to the off-

main diagonal, the greater the quality.

b. Except under ideal conditions, net income does not completely capture all

events affecting firm value for the following reasons:

• Historical cost-based accounting, still a major component of the mixed

measurement model, lags in recognizing many value-relevant events such as

management changes, new processes and patents, discovery of natural

resources, production of inventory, etc. Thus, there are many factors

affecting share price that the efficient market will recognize prior to financial

statement recognition. Consequently, investors may not give full attention to

reported earnings, preferring to rely on more timely information sources.

• The informativeness of price, particularly for large firms. Other sources of

information, such as the media, company announcements, quarterly reports,

are often more timely than earnings. Thus, the market will anticipate much of

the information content of net income, leaving less for the market to react to

at the earnings release date.



• The presence of liquidity or noise traders means that there are always

random factors affecting share price. Net income would not be expected to

explain these.

• Non-stationarity. Share price parameters such as beta may shift over time.

This will affect share price but is not explained by net income.

• Non-rational investors. Investors subject to self-attribution bias may overreact

to good news, leading to share price momentum, or underreact to bad news.

Investors subject to limited attention may not process all available

information. Both of these characteristics will reduce or delay share price

reaction to net income.

c. Increased use of a measurement perspective in financial statements will

raise earnings quality if the resulting increase in relevance outweighs the

decrease in reliability. Relevance increases because there is less of a lag

between the occurrence and recognition of value-relevant events such as

changes in fair values of investments, capital assets, changes in the present

value of long-term debt, pensions, post-retirement benefits, etc. Reliability will not

decrease providing fair values are based on well-working market prices.

However, to the extent such market values are not available, greater use of

measurement may decrease representational faithfulness and verifiability, and

increase possibility of bias. If the effect on relevance is greater than the effect on

reliability, the main diagonal probabilities of the information system increase.

That is, earnings quality increases. Then, we would see a larger response of

security prices to the good or bad news in earnings (i.e., higher ERC).

7. From a single person decision theory perspective, reported earnings are value

relevant if they lead to buy/sell decisions, caused by investors revising their

beliefs about future firm performance, during a narrow window surrounding the

date of release of the earnings information. Buy/sell decisions in turn lead to

changes in share prices and returns.

R2 measures value relevance of earnings information since it is the proportion of

the variability of abnormal share return explained by the GN or BN in reported



earnings during a narrow window surrounding the earnings release date—the

higher is R2 the greater the value relevance of reported earnings since a greater

proportion of the change in share price during the narrow window is then

explained by the earnings information.

ERC measures value relevance of earnings information since it is the amount of

abnormal share return per dollar of earnings GN or BN. The higher is the ERC,

the greater is the value relevance of reported earnings since a high ERC means

that the earnings information has a high impact on investor buy/sell decisions.

Note: The ERC is affected only by the reported earnings information. R2 can fall

even if the effect of earnings information on share price holds steady or

increases, since a decrease in R2 can also be due to the effects on investor

decisions of an increase in the information provided by factors other than

reported earnings. This other information would be captured by the residual term

of the returns/earnings regression. In this scenario, the fall in R2 is due to more

share price variability to be explained, rather than necessarily to a decrease in

the quality of earnings per se.

Yes, it is possible for R2 and ERC to fall but abnormal return to increase if other

firm-specific factors accompany the earnings announcement. Abnormal return

includes the effects of all firm-specific factors affecting share price, while R2 and

ERC capture only the effects of reported earnings. Other firm-specific factors

which may accompany the earnings announcement include announcements and

forward-looking information from company officials, information on unusual and

non-recurring events, analysts’ comments, and media articles. This information

will also affect buy/sell decisions. Thus it will affect abnormal return even though

it may not affect R2 or ERC.

8. One reason is that the level of profits reported from the “beat-the-market”

strategies seems too high to be explained solely by transactions costs. For

example, Bernard and Thomas (1989) earned an average annual return of 18%

over and above the return on the market from their post-announcement drift

investment strategy. Excess returns are also reported by Sloan (1996).



More fundamentally, there are no theories or models to predict what transactions

costs should be. Lacking these, any level of profits could be claimed to be

because of transactions costs, which clearly does not resolve the question of

whether transactions costs solely explain the anomalies.

Another argument against a transactions cost-based explanation of the

anomalies is that large investors, including pension funds, mutual funds, financial

institutions, may have the market clout, resources and expertise to lower

transactions costs. The economies of scale that these investors may attain could

enable them to engage in sophisticated investment strategies at relatively low

cost. If the anomalies earn excess returns over the market even in the presence

of these low-cost investors, the adequacy of a transactions cost-based anomalies

explanation is further reduced.

Finally, transactions costs are only one barrier to arbitrage. Another barrier is

idiosyncratic risk. To fully explain efficient securities market anomalies,

idiosyncratic risk must also be considered.

9. Transactions costs. To the extent there are costs to exploit securities market

efficiencies, investors will not fully eliminate share mispricing through arbitrage.

This allows anomalies such as post-announcement drift and the accruals

anomaly to continue.

Idiosyncratic risk. To exploit market anomalies, investors must depart from a

strategy of portfolio diversification. Then, firm specific risk becomes a larger

component of the investment portfolio. Since risk averse investors trade off risk

and return, increased risk inhibits their investments in mispriced securities. This

allows the anomalies to continue.

10. a. The information is potentially useful to investors since it emphasizes that

earnings do not augment firm value unless they exceed expected earnings, that

is, earnings greater than the cost of capital used to earn them. This is consistent

with the clean surplus Equation 6.1, where goodwill is the present value of future



abnormal earnings. The EVA information may help investors to evaluate the

goodwill component of firm value.

A counter argument is that investors already have sufficient information

(including cost of capital, which can be estimated from the CAPM, or by inverting

the clean surplus formula–see last paragraph of Section 6.5.4) to calculate EVA

for themselves. Given securities market efficiency, the information in the EVA

would be incorporated into share price as soon as the current year’s earnings

and financial statements were released. Thus, while it may serve as a

convenience for investors who do not wish to make the calculations for

themselves, the EVA adds little to the information possessed by the market.

Since the firm may have a better estimate than the market of its cost of capital, a

possible exception is that the market may obtain a better cost of capital estimate,

assuming the firm discloses this rate in its capital charge calculations.

The relevance of EVA is high or low depending on which of the foregoing

arguments is accepted.

With respect to reliability, the EVA information is similar in reliability to the

financial statement information on which it is based. If capital employed and net

operating profit are based on historical cost accounting, reliability would be

relatively high. To the extent that they are based on current values, reliability may

be lower, depending on the extent to which well-working market prices are used

in the fair value calculations.

b. EVA may discourage the top manager from initiating major capital

expenditures since these would carry with them an automatic capital charge.

Even if the expected value of a project exceeds the capital charge, the manager

may be discouraged if the project is risky. The riskier the project, the higher the

probability that project earnings may dip below cost of capital at some point,

resulting in a negative EVA.

Of course, discouraging capital investment is not necessarily bad, since EVA

puts managers on notice that new investment should earn at least its cost of



capital. Thus, the discouragement would be primarily with respect to marginal

and/or risky projects.

c. Given that the intangible assets are not included in the capital base, the

effect would be to raise the reported EVA. As a result, the greater the proportion

of unrecorded intangibles in firm value, the higher the EVA would have to be

before it is interpreted as satisfactory. This is because unrecorded intangibles

show up in reported earnings over time as their value is realized, not in the

capital base. In clean surplus terms, they are part of abnormal earnings rather

than part of the balance sheet.

Another interpretative aspect is that to the extent intangibles are not included in

the capital base, the firm may overinvest in expenditures that create unrecorded

intangibles, such as R&D.

Notes: For further discussion of these and other aspects of EVA, see

also, “Valuing Companies: a star to sail by,” The Economist, August 2,

1997, pp. 53-55.

Since amortization of purchased goodwill was removed from GAAP in 2001 in

Canada and the U.S. and 2004 internationally (see Section 7.4.2), purchased

goodwill is fully included in the capital base for EVA. Prior to 2001/2004, such

goodwill was included in the capital base only to the extent it was not amortized.

One can then raise the question of whether or not the elimination of amortization

imposes greater discipline on managers of parent companies not to overpay for

acquisitions.

Instructors who wish to consider the accounting, or lack of accounting, for

unrecorded intangible assets and its effects on reported earnings and EVA in

greater depth may find the following suggestion of interest:

Numerous authors have pointed out that the value of many

firms, such as the high tech firms mentioned in part c, comes

primarily from intangible rather than tangible assets. This raises

questions about the adequacy of historical cost-based



accounting for such firms. Intangible assets are seldom

recorded, unless they have been purchased (see Section

7.4.2), despite the lack of relevance that ensues. The reason for

not recording self-developed intangibles, presumably, is due to

problems of reliability. In effect, the accountant throws up

his/her hands and requires immediate writeoff of expenditures

such as advertising, R&D, and employee training. As

mentioned, intangibles do show up, but only as realized over

time in the form of higher earnings and EVA.

In this regard, The Economist, (June 6, 1998, p.64) contains an

outline of a proposal by Edvinson and Malone (Leif Edvinson

and Michael Malone, “Intellectual Capital,” Harper Business,

1997). To arrive at a value for total intangible assets (i.e.,

intellectual capital), these authors suggest that the fair value of

net physical assets be deducted from the market value of the

firm. Intellectual capital is then prorated into various

components, such as human capital, patents and copyrights,

etc. These values can then serve as the basis for a

“constructive debate” as to whether the capital market has over

or undervalued their real worth.

However, this suggestion is unlikely to add much to what the market

already knows about the value of intangible assets. The difference

between the firm’s market value and the fair value of its net physical

assets is the market’s assessment of the value of its goodwill. The role of

financial reporting is to add to what the market knows, not simply to

reflect what it knows. There thus seems little scope for a “constructive

debate.”

d. Yes, it adds credibility. Domtar’s management would hardly be expected

to report voluntarily the rather bleak EVA this year if they did not expect to do

better next year. In effect, reporting EVA this year puts their expectations for next



year on the line. The market would realize that they must have plans to turn

operations around.

Note: Domtar did not do better in 1997, and its 1997 annual report contained only

brief reference to EVA.

11. According to clean surplus theory, the firm’s opening market value is:

32.526$14.1

30500

14.1)50014.100(500

exp1

=+=

×−+=

+= earningsabnormalfutureectedofvaluepresentvalueBookPA

Note: Many students answer this question as $500 + 100/1.14 = $587.72. This is

incorrect as it ignores the fact that firm value consists of net assets as per the

balance sheet plus the discounted present value of expected future abnormal

earnings. Failure to deduct a capital charge overstates firm value, since the

market expects the firm to earn its cost of capital on opening investment, and

only values the abnormal portion of future earnings. To put this another way, the

$500 book value of the firm’s assets would have to be written down if they could

not earn cost of capital, according to ceiling test standards.

12. I have used this assignment on numerous occasions. Most students seem to

enjoy it. I find that application of the “recipe” to value Canadian Tire Corp. in

Section 6.5.3 is usually well done, although the instructor may assist students to

evaluate the expected return on the market by discussing the concept of market

risk premium described in Note 21 of this chapter. Stocks’ betas are usually

available on the internet—Reuters and Yahoo Finance are good sources. If not, it

is relatively straightforward to estimate beta directly, as I had to do for Canadian

Tire—see Note 22. A complication is that many Canadian firms have a dual

common share structure—see Note 23. While rather ad hoc, I suggest simply

adding the number of shares of each class.



The main problem students have with this assignment is to see beyond simply

applying the procedure. Consequently, an important part of the assignment is to

consider the effect of recognition lag, such as for R&D, on the calculations, and

to consider the pattern and length of time that abnormal earnings are expected to

persist. In my opinion, the main reason that the estimated share value is often

less than the actual market share price is that the market has greater

expectations about the amounts and duration of abnormal earnings than seems

reasonable. I recommend discussing with the students (I do it after the graded

assignment is handed back) issues surrounding the assumptions about abnormal

earnings, although in an undergraduate course I do not go into the terminal value

problem of estimating firm value beyond the specific earnings forecast horizon (I

use a 7 year horizon for Canadian Tire).

13. Your decision is whether or not to go along with management’s request.

Reasons to go along:

• If you do not go along, you may suffer demotion or be fired, or be forced to

resign. In contrast, if you go along, you will possibly earn management’s

approval and consequent rewards.

• Recognizing revenue early increases earnings relevance, since investors

get an earlier reading on future firm performance.

• If business picks up next year, the early revenue recognition this year may

never be noticed, since reduced revenue recognized next year (as current

year’s revenue accruals reverse) will be outweighed by revenue from new

business.

• Since GAAP requires considerable judgement in its application, other

expert accountants and auditors may conclude that, despite your

reservations, the extra revenue recognition does not really violate GAAP

under the circumstances.



• If the auditor goes along with management’s request, you can blame the

auditor should the early revenue recognition be discovered.

Reasons to not go along:

• Deliberate GAAP violation is unethical. If discovered, this will lower your

reputation, the reputation of management and the company. Investors will

lose confidence and share price will fall.

• If you go along, management’s opinion of you may actually decline. You

could be viewed as easily manipulated and of low standards. This would

increase the likelihood of similar demands in future.

• Early revenue recognition lowers earnings reliability. There is a substantial

probability that actual earnings on the contracts in process will differ from

the amounts currently projected.

• Management’s optimism may prove to be unfounded, and next year’s

business may not pick up. This increases the probability that the early

revenue recognition this year will be discovered.

• Should the auditor not go along, you, management, and the company will

become involved in extensive arguments and negotiations with the auditor.

This will be costly, time-consuming, and may lead to auditor resignation or

a qualified audit report, with attendant bad publicity.

14. a. An auditor might be tempted to “cave in” to client pressure to manage

earnings for the following reasons:

• GAAP are often vague and flexible about specific accounting procedures. For

example, there is considerable flexibility with respect to revenue recognition,

the useful life of capital assets, and provisions for future liabilities such as site

restoration. Such procedures are subject to estimation errors and

management bias, hence unreliable. While vagueness and flexibility can be

used to report higher current earnings, this comes at the expense of earnings



in subsequent years, since accruals reverse. Nevertheless, the auditor may

feel that such tactics are acceptable if they do not violate the letter of GAAP.

• Efficient securities market theory implies that information in MD&A or in notes

to the financial statements will be fully incorporated into share prices. Then,

the auditor may feel he/she is “off the hook” if these contain information that

allows the market to detect and evaluate earnings management policies in the

financial statements proper.

• The auditor may feel that he/she will lose future audit and other business from

the client firm if management’s pressure is not accepted.

Longer-run costs to the auditor who yields to client pressure include:

• Lawsuits, when vague and misleading information in the financial

statements becomes known.

• Reduction in reputation, when vague and misleading information in the

financial statements becomes known.

• Reduced public confidence in financial reporting, leading to a loss of

business. Since audits will be perceived as less valuable by investors,

firms in general will reduce the amount of auditing they engage—why pay

the same audit fees if the audit product is not as valuable?

• Reduced public confidence in financial reporting, leading to increased

regulation such as Sarbanes/ Oxley (see Section 1.2). One result of such

regulation is a reduction in the types of non-audit work the auditor can

undertake for the audit client.

Note: Increased regulation can also have benefits for the auditor. For

example, a provision of the Sarbanes/Oxley Act is that management must

certify the fairness of the financial statements, and must certify the

adequacy of the company’s internal controls over financial reporting. It is

likely that management will want increased audit work, including

examination of internal controls, before signing such a certification.



Furthermore, the auditor’s ability to stand up to management is

strengthened. This is due, for example to the requirements under the Act

that the auditor reports to the audit committee rather than to management,

and that the audit committee be composed of independent directors. In

addition, the Act creates the Public Company Accounting Oversight Board.

This agency has the power to set auditing standards and to inspect and

discipline auditors of public companies. If it operates as it should, future

reporting scandals and resulting lawsuits will be reduced.

b. To the extent that current values are determined by fair value on properly

working markets, client pressure would likely be reduced, since it is difficult for

management to manage or bias market prices. If current values are determined

by means of value-in-use measures such as present value, client pressure would

remain since numerous estimates are required. The auditor may have little

alternative than to accept many of these estimates.

Current values, including ceiling tests, are future oriented relative to historical

cost values. Thus, declines in current values, which typically precede business

failure, would be contained in the financial statements proper under the

measurement approach. This would reduce auditor exposure to lawsuits since

the auditor could claim that information predicting a business failure was explicitly

disclosed, and thus less subject to being missed by investors with limited

attention or other behavioural characteristics.

c. Behavioural concepts leading to market overreaction to earnings

expectations include self-attribution bias, representativeness, and

overconfidence. Self-attribution bias causes investors’ faith in their investment

ability to rise following GN in earnings, leading to the purchase of more shares

and development of share price momentum. Momentum is reinforced by positive

feedback investors, who buy when share price starts to rise, and vice versa.

Investors subject to representativeness assign too much weight to current

evidence, such as earnings growth. Then, the market will overreact to GN in

earnings.



Overconfident investors overestimate the precision of information they collect

themselves, such as financial statement information. Then, if the firm reports,

say, BN they revise their probability of poor future firm performance by more than

they should according to Bayes’ theorem. This leads to share price overreaction

to the BN.

Market overreaction to (negative) changes in earnings expectations is also

predicted by prospect theory. Under this theory, a reduction in prospects for

future earnings lowers investor utility by more than it is increased by a

corresponding increase in prospects. Then, we would expect a relatively strong

market reaction if earnings forecasts are not met. However, prospect theory also

predicts that investors will tend to hold on to ”loser” stocks. This would tend to

reduce, rather than increase, market reaction to a reduction in earnings

expectations. Thus, the extent to which investors’ probability weightings

contribute to market overreaction under prospect theory is not clear.

d. It is difficult to fully evaluate consistency with securities market efficiency

without information on the risk-free interest rate, Kodak’s beta, and the

performance of the market index on the day of Kodak’s announcement. Share

price did fall after the bad-news announcement, but we cannot tell whether or not

the fall is more or less than what would be expected due to market-wide factors

on that day.

However, if we assume that market-wide effects were relatively small, note that

analysts’ estimates of Kodak’s earnings per share fell by .10/.90 = 11.1%.

Kodak’s share price fell by 9.25/(79. + 9.25) = 10.5%. Given that investors use

current earnings to revise their probabilities of future earnings, hence of future

firm performance, the reduction in Kodak’s share price seems reasonable, hence

not seriously inconsistent with securities market efficiency. However, share price

subsequently rose by 2.25/73.12 = 3% following a .01/.80 = 1.25% excess of

reported EPS over analysts’ estimates. This seems less consistent with efficient

securities market theory.



Note: These calculations ignore investors’ prior probabilities. For example, an

investor with very low prior probabilities that Kodak’s future performance will be

low would not react as strongly to Kodak’s earnings shortfall as an investor with

very high prior probabilities of low performance.

15. a. The calculation of economic profit by TD is related to the estimation of firm

value under clean surplus theory since they both involve the deduction of a cost

of capital charge from reported earnings, to arrive at abnormal earnings.

They differ, however, in the time periods to which they apply. Under the TD

economic profit approach, abnormal earnings are reported only for the current

period. Under clean surplus theory, it is expected future abnormal earnings that

are calculated. If an accurate estimate of goodwill and other intangibles was

recorded on TD’s balance sheet (unlikely, since GAAP does not allow the

capitalization of self-developed goodwill, for example), there would be no future

abnormal earnings (they are all capitalized on the balance sheet). Also, there

would be no abnormal earnings in the current year. Since TD does report

abnormal earnings for the current year, the relationship between its calculation

and clean surplus is rather distant.

Note: Some students may question the adding back of goodwill/amortization of

intangibles to date to invested capital for purposes of the economic profit

calculation.

The likely reason for adding back goodwill/intangible amortization to date to

invested capital is that that the bank regards income before amortization of

goodwill and intangibles as better measuring bank performance. Thus it adds

amortization back to economic income. But if goodwill and intangibles are not

amortized, the cost of these items must be regarded as part of capital, for

consistency.

Note that only amortization of intangibles (i.e., not amortization of goodwill) is

added back to economic income. This is because accounting standard setters

have eliminated amortization of goodwill (Section 7.4.2). Thus there is only

amortization of other intangibles charged against income in 2005. All previous



intangible amortization is added back to capital, however. This addback includes

goodwill amortized prior to the date of elimination of goodwill amortization.

b. It is likely that TD has unrecorded goodwill. Its ability to earn more than its

cost of capital in 2005 suggests that it does.

However, unrecorded goodwill exists only if future abnormal earnings are

positive. TD has not estimated these.

We may conclude that TD has unrecorded goodwill if it is able to continue

earning more than its cost of capital.

c. Either earnings number can be regarded as more useful.

Arguments that net income is more useful include:

• Investors can estimate cost of capital and economic profit for

themselves. They have no need for a second profitability measure.

• There is no GAAP for calculation of economic income. TD has

added back amortization of intangibles to capital and added current

year’s amortization and items of note to economic income. There is

no guarantee that other firms reporting economic income would do

the same thing. This affects the comparability of economic income

across firms.

• One can question TD’s assertion that items of note, such as losses

on derivatives, preferred share redemption costs, etc. are not

indicative of manager performance. Net income includes these

items, and as such is a more comprehensive measure of

management performance.

• The capital charge is based on the CAPM. This ignores estimation

risk. Then, cost of capital is understated and economic income is

overstated. This may give investors an exaggerated impression of

TD’s earning power.



• Economic income is similar in concept to EVA (see Question 10 of

this chapter). Like EVA, it is subject to problems of interpretation if

the firm has substantial unrecorded intangible assets.

Arguments that economic income is more useful include:

• TD may have a better estimate of its own cost of capital than

investors (although this seems unlikely since it is estimated using

the CAPM). Then, economic income is useful because it improves

the information available to the market.

• To the extent that investors have limited attention, economic

income may be more useful since it removes the need for them to

make their own calculations. As a result, such investors will have a

better evaluation of firm performance than if only net income is

reported.

• Items of note may have low persistence. Then, ignoring them may

improve investors’ ability to predict future firm performance.

Focussing on economic income, either construct may be argued as more useful:

If economic income before intangible amortization and items of note is argued as

more useful, a reason follows from management’s view that intangible

amortization and items of note do not reflect underlying bank performance. This

suggests that management believes they are of low persistence. Since it is

underlying performance that will largely determine the bank’s future earnings and

share price, economic income before intangible amortization and items of note

may be more useful to investors who wish to predict future firm performance.

If economic income after intangible amortization and items of note is regarded as

more useful, a reason is that intangible amortization and items of note are valid

expense items and are likely to recur. For example, management has paid for

goodwill and other intangibles arising from acquisition of subsidiary companies,

and may well acquire other subsidiaries in future. Earnings should bear any



resulting amortization and ceiling test writedown expense. Also, while the items

of note may be of low persistence, similar items are likely to arise in future.

Consequently, they should be taken into account when predicting future firm

performance.

16. a. These events do not appear inconsistent with market efficiency. The

missing copper inventory and the overvaluation of restructuring costs and

goodwill appear to have been inside information until revealed by the company in

1998. For example, the audited financial statements for 1995 and 1996 must not

have mentioned these overstatements, nor did the unaudited information in the

1997 prospectus. Market efficiency is usually defined relative to publicly available

information. When the information was made public, share price quickly fell.

b. It is unlikely that fair value accounting would reduce the possibility of the

inventory overstatement in this episode. It was inventory quantity that was

overstated, not an overvaluation of a correct quantity.

c. Ceiling tests may help to reduce auditor liability because they assist the

auditor to resist manager pressure to overstate assets, or to delay release of bad

news that asset values have fallen below cost or amortized cost. Managers may

argue that the firm intends to hold the assets to maturity and that current values

are therefore not relevant. The auditor can better resist such manager pressure

because ceiling tests are part of GAAP, which the ethical auditor cannot ignore.

As a result, if the ceiling test is applied and the firm becomes financially

distressed, it is less likely that assets will be found to have been overstated

relative to their fair values. As the Deloitte & Touche settlement illustrates,

auditors are frequently held liable for such overstatements.

Additional Problems

6A-1. On January 26, 1995, The Wall Street Journal reported that Compaq Computer

Corp. posted record 1994 fourth-quarter results. Despite $20.5 million in losses

from the December, 1993, Mexican currency devaluation, and losses on currency



hedging, earnings grew to $0.90 per share from $0.58 in the same quarter of

1993, on a revenue growth of 48%. Furthermore, Compaq captured the No. 1

market share spot, with shipments up 50% from 1993 and with slightly higher

profit margin.

Nevertheless, on the same day, Compaq’s share price fell by $5.00, a decline of

about 12%. The Journal reported that analysts had been expecting earnings of

about $0.95 per share. Also, there were concerns about Compaq’s scheduled

introduction of new products in March 1995, following a warning by Compaq’s

CEO Eckhard Feiffer that first-quarter, 1995 earnings were likely to be “flat.”

Required

a. Use single-person decision theory and efficient securities market theory to

explain why the market price fell.

b. Assume that the $20.5 million in losses from peso devaluation and

currency hedging are a provision (i.e., an accrual), not a realized cash loss, at the

end of the fourth quarter. Use the anomalous securities market results of Sloan

(1996) to explain why the market price fell.

c. The Journal quoted an analyst as stating “the market overreacted.” Use

prospect theory to explain why the market might overreact to less-than-expected

earnings news.

d. Which of the above three explanations for the fall in Compaq’s share price

do you find most reasonable? Explain.

6A-2. In the MD&A section of its 2000 Annual Report, Royal Bank of Canada reports

“economic profit.” This consists of cash operating earnings less a capital charge

of 13.5%, being the bank’s cost of common equity capital. The amounts for the

last two years are as follows:



2000 1999

Net income after preferred share dividends ($ millions) $2,140 $1,600

Add amortization of goodwill, other intangibles,

and one-time items 87 168

Cash operating earnings 2,227 1,768

Capital charge (1,460) (1,386)

Economic income $767 $382

Required

a. Relate the concept of economic income here to the clean surplus

valuation procedure in Example 6.2. Does Royal Bank have unrecorded

goodwill? (No calculations needed.)

b. Royal Bank also breaks down results for its major business segments. For

example, the personal and commercial financial services segment contributed

$469 million of the $767 total economic income for 2000. If you were the

manager of a Royal Bank segment, would your propensity to incur large capital

expenditures be affected by your knowledge that economic income was a factor

in evaluating your performance? Explain why or why not.

c. What new information, if any, is conveyed to the market by Royal Bank’s

disclosure of cash operating earnings and economic income? Why does Royal

Bank make these disclosures?

Suggested Solutions to Additional Problems

6A-1. a. According to single person decision theory and efficient securities market

theory, the share price fell for one or more of the following reasons:

• Earnings came in below expectations of $.95 per share. This would cause

investors to revise downwards their expectations of future earnings performance.



• Second, concerns about new products and the forecast of “flat” earnings would add

to investors concerns about future earnings. Both of these effects would trigger sell

decisions, driving down the share price.

• Beta may be non-stationary. Investors may have increased their perceptions of

Compaq’s beta risk. This would increase the expected return demanded by the

market (see Equation 4.3), leading to a drop in the current share price (see

Equation 4.2).

b. The provision has a less persistent effect on earnings than a cash loss, since

accruals reverse. If so, the efficient market should react less negatively to the

provision than to a realized cash loss. Sloan’s finding, however, was that the market

did not make this distinction. Thus, the strong negative market reaction to Compaq’s

earnings could be explained as an anomaly–the market reacted more strongly than it

should have to the $20.5 million loss provision.

c. According to prospect theory, investors overweight low probabilities and

underweight high ones. Assuming that the foreign currency losses and the failure to

achieve expected earnings are rare events for Compaq, investors may overweight the

low probability that they will recur and underweight the relatively high probability that

operations will revert to normal levels.

Furthermore, the lower-than-expected earnings creates a loss in value for investors.

Under prospect theory, investors exhibit loss aversion—they react strongly to small

losses (see Figure 6.2).

Note: Loss aversion implies that investors will tend to hold on to “loser” stocks,

however. If so, this would reduce, not increase, the downward pressure on Compaq’s

share price.

All of these effects could explain the strong negative reaction.

d. The chosen explanation is clearly a matter of judgement and preference. Any of

the explanations can be accepted as most reasonable providing that reasonable

justification is given. Points to consider include:



• The efficiency explanation has considerable theory (i.e., single-person decision

theory and the CAPM) behind it. Even the very volatile market response is

consistent with the theory if we recognize that Compaq’s beta may not be

stationary. Then, rational investors may have different estimates of beta,

causing them to react differently to the same information. This introduces

additional volatility into the economy.

• Prospect theory also has a theory behind it. It is based on a behavioural view of

human nature, in particular the concept of narrow framing, rather than a strictly

economic view. This explanation would be favoured by those who believe that

the securities market is driven by behavioural factors as well as economic ones,

and is reinforced by the feeling of at least one analyst who stated that the

market “overreacted.”

• Sloan’s findings are consistent with both a behavioural explanation and a

rational investor explanation. Barriers to arbitrage, specifically transactions

costs and idiosyncratic risk, prevent the anomaly from being quickly arbitraged

away, although transactions costs are not a very satisfactory explanation

without knowledge of what these transactions costs should be.

• Fama (Section 6.2.8) argues that alternative models to efficient securities

markets have not yet explained the “big picture.” In effect, his argument is that

the weight of empirical evidence still favours the rational economic view of

securities price formation.

6A-2. a. Royal Bank’s concept of economic income is related to the clean surplus

valuation procedure through the concept of goodwill. Economic income shows the

current instalment of the ability of the bank to earn a return greater than its cost of

capital. Ability to earn an excess return on capital is the essence of goodwill. The

clean surplus valuation procedure capitalizes the expected future stream of

excess earnings.

The Royal Bank’s procedure differs from the clean surplus procedure, however,

since it applies to the current year, not to future years. Current year’s

performance is already incorporated into the balance sheet under clean surplus.



It seems, however, that Royal Bank does have unrecorded goodwill. If it did not,

economic income (i.e., abnormal earnings) for the current year would be zero.

This is because if all unrecorded intangibles were recorded on the balance sheet

at their fair value, the bank would earn only its cost of capital on total net assets.

b. Yes. I would thoroughly evaluate large capital expenditures. These would

be accepted only if there was a high probability of a return greater than the cost

of capital. I would tend to avoid risky projects because if the expected high

returns did not materialize my economic income would be negative. This would

adversely affect my performance evaluation.

c. Little, if any, new information is conveyed to the market by economic income.

The market can estimate Royal Bank’s cost of capital and can make the

economic income calculation for itself.

There would be new information conveyed if Royal Bank’s cost of capital of

13.5% differed from the market’s evaluation, and reflected inside information of

management.

Adding back goodwill amortization and other intangible and one-time items to

determine cash operating earnings could assist the market in evaluating Royal

Bank’s earnings persistence if these items were not fully disclosed in the financial

statements.

The bank may make the cash income and economic income disclosures because

it feels that these earnings concepts better portray its results of operations.

Alternatively, the bank may feel that amortization of (recorded) goodwill and other

intangibles does not reflect its financial performance. Consequently, it adds these

back to determine what it calls cash operating earnings. However, it may feel

defensive about its high cash operating earnings, which seem high relative to its

cost of capital, and may want to try to convince investors, and the public, that

profitability should be measured after a capital charge. Since this produces a

lower number, the bank may feel that concern about excessive bank profits will

be reduced.