LECTURE 1: IDEAL CONDITIONS: proxies for expected prices ii) Estimates are needed to apply RRA iii) The

or expected prices ii) Estimates are needed to apply RRA iii) The Mild version is that he says it must be their lucky day and that they should pick it up theoretical framework supportive of the valuation approach. III) Low share of
consideration of proved reserves is itself subjective because it means there’s quick because the mkt is so efficient that it wobe there for long. Finding it is so rare earnings information in explaining share price changes relative to other information
What are the ideal conditions? Ideal condition means perfect and complete markets reasonable certainty of recovery under current economic, regulatory, and operating that finding a 10$ note would be a waste of time and foolish. sources. More current-value accounting may increase accounting’s “market share” in
where there is no information asymmetry and accounting reports in this setting are conditions. Iv) Estimates are subject to bias and errors. DEMAND FOR ACCOUNTING INFO IN EFFICIENT MARKETS: explaining share price changes. IV) Reduce auditor liability.
both, relevant and reliable. Perfect markets - every party has the same level of RELEVANCE VS RELIABILITY: Efficiency is defined relative to the publicly available info. If the info that is available DECISION USEFULNESS & EFFICIENT MKT HYPO:
information or can obtain information without costs. Complete Market- anything Relevant Info: Informative of future performance. Reliable Info: Representationally is of poor quality, if there is not “enough” of it, or If it is simply wrong, then prices will Decision usefulness is based on the efficient mkt hypothesis which is not true in reality.
that anyone cares about can be sold. Accountant’s role in this setting is very lil as faithful and free from bias. Greater relevance requires more estimates but more reflect this. Poor quality accounting information increases the information Proved by I) Bernard & Thomas- Post Earning Announcement Drift: Abnormal share
inv have the same info as managers. estimates decrease reliability. asymmetry between a firm and its investors. In the presence of information returns drift upwards or downwards for several months following GN or BN in
Relax ideal conditions  information asymmetry problem: information relevant to Historical costs favors reliability while FV favors relevance. asymmetry (in particular adverse selection), investors discount the information quarterly earnings. Efficient securities market theory predicts immediate response
evaluate the firm is no longer costlessly available. Causes 2 issues: So which val model is used?  Mixed model where assets are at historical cost but provided by the firm and consider the firm riskier (i.e., higher estimation risk) . to GN or BN in reported earnings. II) Sloan- Accruals: Cash flows are more
1) Adverse selection problem: One or more parties have the info advantage over the subject to impairment. Thus accounting info has some role to play in order to make inside info to publicly persistent than accruals but the market treat them as they are equal.
other parties in a (potential) business transaction (i.e inside info). Other parties do not TAKEAWAYS FROM THiS LECTURE: True economic income, which is defined available info. BERNARD & THOMAS: POST EARNING ANNOUNCEMENT DRIFT:
have the info to separate a good firm from a bad one. as an objective income that everyone agrees on, does not exist if no ideal setting. SOCIAL SIGNIFICANCE OF MARKET THAT WORKS WELL: They stated that seasonal earnings changes are positively correlated for up to 3
2) Moral Hazard Problem: One or more parties can observe their actions but other In a capital economy, allocation of scarce capital is accomplished by mkt prices. subsequent quarters. Investors take a lot of time to figure out or they underestimate the
parties cannot. (eg. Unobservability of manager effort). But here the question is how LECTURE 2: DECISION USEFULNESS APPROACH TO FINANCIAL Higher share prices attract more capital. Capital allocation is most efficient if share magnitude. Buying Gn shares and selling Bn shares on the day of announcement led to
to reduce this? By providing incentive-based compensation. REPORTING: prices reflect fundamental value. Higher share prices reflect higher fundamental value. an avg return of 18% over the mkt.
ADVERSE SELECTION PROBLEM: Therefore, Social Significance of financial reporting: Maximise amount of publicly SLOAN: CFS MORE PERSISTENT THAN ACCRUALS
Definition: Given Above. Concept of decision usefulness: If we cannot prepare theoretically correct financial available info. THIS IS SUBJECT TO A COST-BENEFIT CONSTRAINT: Sloan (1996) argues that the cash flow component of earnings is more persistent than
Implication: Since investors cannot distinguish between good and bad firms, they statement, we can at least make it useful. Non-ideal conditions provide a role for Litigation risk, Proprietary cost, Direct cost, etc. the accrual component. If investors understand this, they should respond more
either walk away from the investment or apply heavier price discounts. financial statements to be useful. The role of accounting depends on how users make IMPLICATION OF FINANCIAL REPORTING: strongly to the GN or BN news in earnings the greater is the cash flow component
Mitigation Way in capital markets from the accounting perspective: i) Understand decisions and how users use info (eg. Accounting reports). Therefore, to understand i) Full-disclosure- including accounting policies: The more information is disclosed, relative to the accrual component. By buying shares of low-accrual firms and short
how investors use info in making decisions ii) Firms voluntarily disclose more and how accounting can be useful for decision making, we must first understand how the narrower is the gap between efficient prices and fundamental value ii) Accounting selling shares of high-accrual firms, and holding for one year, one can earnings 10.4%
high-quality accounting information iii) The decision usefulness (i.e. Information) individuals use information and how they make decisions! policies do not matter (unless with cash flow effects): As long as accounting policies return above mkt return.
role of the accounting information. Decision usefulness is the ability of financial accounting info to help investors make are disclosed and have no cash flow effects, investors will see through the “cosmetical Why are securities mkt not fully efficient? I) Behavioral Finance: A) limited
Intuition behind this problem: Assume one has no way of distinguishing between good decisions. It was incorporated in the Conceptual Framework of IASB. The changes”. iii) “Naïve” Investors are price protected: Efficient price can be relied by attention leads to investors not using all the info. As a result, investors continue to
choice A which is of 10 bucks and choice B which is of 20 bucks. What is likely to objective of general purpose financial reporting is to provide financial information uninformed investors to make good investment decisions. iv) Accountants are in ignore full info content of FS. B) Overconfi: We tend to overestimate the precision of
happen in an online auction is that I will not be willing to pay more than 15 bucks about the reporting entity that is useful to existing and potential investors, lenders competition with other information providers: Any value relevant information can self-collected data. C) Representativeness: We give more weightage to some kind of
for it. Only sellers of choice A will list their products since the choice B sellers will and other creditors in making decisions relating to providing resources to the entity. affect stock prices. evidence. D) Self-Attribution bias: Ascribe success to ownability. II) Transaction
incur a loss. What can be a solution for this?  voluntarily provide more info (eg. Key elements of the single person decision theory: i) Non Ideal conditions ii) EXAMPLES OF FINANCIAL REPORTING IN EFFICIENT MARKETS: MD&A- costs are too high: It may not be worth exploiting anomalies if costs are too high (e.g.,
Pics, ratings, descriptions, guarantees, etc). Investment decision iii) rational decision-maker (implied that an individual will always i) Supplements the financial statements ; ii) Provide a forward-looking orientation iii) the cost of shorting stocks).
MORAL HAZARD PROBLEM: make a decision that maximizes his utility. The utility function relates payoff amounts Includes discussion of risks facing the firm. OR Footnote Disclosure. Implication of inefficiency in markets: Rational decision theory model of
Definition: Given Above. to the decision-maker’s utility for those amounts. What roles do these play? Convert inside info to public info. investment is still the most useful model to guide accountants about investor decision
Implication: Inv would want managers to behave in their best interest BUT they Role of risk aversion: Risk aversion is basically how a rational investor reacts to Voluntary/mandatory? MD&A is mandatory in US but providing a forecast is needs. Securities markets are not fully efficient, but close enough so that accountants
cannot observe managers’ efforts. Managers may not work hard or might end up uncertainty. It is the hesitation of the individual to agree to a situation with an optional around the world. can be guided by its reporting implications. Implications on the valuation approach:
taking excessive risks. unknown payoff rather than another situation with a more certain payoff but TAKEAWAYS: i) Efficient securities market is a relative concept, which allows for To the extent that markets not fully efficient, the role of financial reporting increases.
Mitigation Way in capital markets from the accounting perspective: i) Tie accounting possibly lower expected payoffs. informative financial reporting to play a role in improving the accuracy, timing, and Current value accounting helps to fulfil the increased role.
information to managers’ compensation contracts and incentivize managers to work A utility function of a risk averse investor is the square root of payoff amounts. amount of a company’s stock. ii) Full disclosure allows investors to make better OHLESON’S CLEAN SURPLUS MODEL: Firm Value= Book Value + Premium.
hard (e.g., net income as benchmark for CEO bonus) ii) The stewardship/governance decisions and improves the ability of securities markets to allocate resources more Premium is the abnormal earnings. Abnormal earnings= Actual Earnings –
role of accounting information (i.e., align the interests between investors and efficiently. iii) Firms’ accounting policy choices should not affect their cash flows Expected earnings. The expected earning is the cost of capital * net capital
managers). or their stock prices, provided they are applying the full disclosure principle. investment. Therefore, Firm Value= BV + PV of expected abnormal earnings.
Intuition behind this problem: Insurance companies cannot observe insurees’ effort LECTURE 4: VALUE RELEVANCE AND EMPERICAL ANALYSIS: Ex: In the good state, cash flows are $200, and in the bad state, cash flows are $100.
in taking care of their own health. Insurees overspend on medical bills. Definition of value relevance: Acc info has value relevance if mkt price responds to the Assume the probability of each state is 50%. Present value of firm at t=0 is $260.33, at
CURRENT VALUE BASED ACCOUNTING (CVBA): Prior probabilities: Prob (High)= 30% & Prob (Low)= 70%. Therefore expected release of accounting info. Usefulness of the accounting info is defined by the t=1 is $236.4. Assume t=2 is a bad year then, Net Income = 23.64 + 100 – 150 = $-
Types of current values: Value in use- discounted CF. Think of it as PV of the firm. utilities from buying shares: 0.3*√1600 + 0.7*0= 12. Buying bonds: 1*√225= 15. magnitude of price change. 26.36. Assume t=2 is a good year then Net Income = 23.64 + 200 – 150 = $73.64.
OR Fair Value: exit value or opportunity cost (i.e. the amt the firm receives if the asset Therefore, they would buy the bond. The fundamental question: Do investors use accountants’ products? The challenges in E(Net Income) = 0.5 X (-26.36+ 73.64) = $23.64. E(abnormal earnings)=E(net
is disposed off. Think of FV as the mkt price of firm. Now suppose Gill makes a decision based on FS and it is good new? How will they answering this “simple question”: i) when do we look? Short/Long window ii) what acc income)- expected earnings =23.64-236.4*10%=0
How is it a solution to adverse selection?  it favors CVBA: timely and mkt based update the probabilities then? measures to be established? iii) How do we control for other events that affect the stock Zero abnormal earnings represents a special case of ohleson which is called unbiased
info. prices? accounting. Under this, All Assets/Liabs are valued at current value, abnormal
How is it a solution to moral hazard?  CVBA can improve the governance role as Ball & Brown Study: earning do not persist, all firm value appears on BS, Income statement has no info
well since ultimately managers are responsible for everything including current value First study to document the share price movement to Net income announcement. content.
gains and losses. However, the solution may not favor CVBA since mkt conditions are Basic Methodology: Step 1: Issuance of good or bad news?  Significance of Ohleson’s Clean surplus: It provides a framework consistent with
beyond the managers’ control. To assess whether the released is a good/bad news, they looked at the expected NI. the valuation approach, by showing how the market value of the firm can be
Therefore, the more reliable numbers might be the best for evaluating managers but Only the unexpected component would cause a reaction. They took the last year’s expressed in terms of fundamental BS and income statement components. In
they don’t provide relevant info needed to address adverse selec. earnings as the expected earning. Nowadays people use analyst forecast to estimate practice, firms do not record all the assets/liabs at current value. Since Bv is biased
INFORMATION VS GOVT ROLE OF ACC INFORMATION: earnings. Step 2: What is the reaction of firm specific news?  need to separate mkt- downwards relative to MV and the expected abnormal income may not equal 0, this is
- While standard setters emphasize the information role of accounting information, they wide movement. Therefore use a narrower return. Abnormal return= Actual – called biased accounting.
also start to pay attention to the governance role of accounting information. - Corporate Expected return. Expected return is CAPM return = (1- beta) Rf + beta * Rm. first part APPLICATION OF VALUATION APPROACH: I) Accounting for intangibles: A)
governance and accounting regulations in response to market failures: Dotcom (in bold) is the slope. Basically, Use narrower window and delete firms that had Purchased Intangible: GW arising from acquisition is accounted for at cost with no
bubbles and accounting scandals in late 1990s and early 2000s and 2008 Financial other major announcement during that time. amortization but subject to impairment. B) Self-Developed Intangible: GW arising
Concept of information system: Conditional probabilities- Diagonal elements are the
crisis. - ESG disclosure (International Sustainability Standards Board) Causation vs Association: Short window study gives evidence on whether or not FS from R&D is hard to determine FV and cost are written off as incurred. This creates a
key. The higher they are relative to the off-diagonal elements, the more
CONCEPTS OF IDEAL CONDITIONS: WITH CERTAINTY statement causes stock price changes. It is more consistent with the decision recognition lag as value shows up overtime on P&L. FV accounting of financial
informative the info. Accounting info needs to be high quality. Information helps
i) Future CFs are known ii) Discount rates are known. usefulness info. Long window studies gives evidence that FS statement is associated instruments: A) Exit Price: Ideally MV but the mkt incompleteness complicates the
investors to assess the probabilities of several outcomes.
How to prepare Financial Statements? i) Assets/Liabs is the PV of CFs ii) Realized NI with stock price changes. measurement. It measures the opportunity cost of retaining assets/liabs. B) FV
Links to conceptual framework: Provide theoretical foundation for conceptual
= Expected NI. Expected NI= Opening shareholder * Interest Rate. It reflects the EARNING RESPONSE COEFFICIENT: Hierarchy: Level 1- Reasonable well mkt value exists ; Level 2) Price can be inferred
framework- To provide info that is useful of assessing the amounts, timing & certainty
change in shareholder’s equity. Expected NI is also called accretion of discount, which It is the magnitude of change in stock price for each unit of unexpected eanings. It from MV of similar items ; Level 3: Managers use their judgement on how a mkt
of CFs. Justify imp characteristics of conceptual framework- Relevance- Makes impact
reflects the accrual of value as the timing of the payoff of cash flow is closer. measure how strong investors respond to earnings announcement. ERC= (Change in participant would value these. As we go down on levels, reliability goes down.
on decision-making and faithful rep- must faithfully represents the phenomena that it
CONCEPTS OF IDEAL CONDITIONS: WITH UNCERTAINTY stock price / Change in unexpected earnings). LECTURE 5: EFFICIENT CONTRACTING THEORY:
purports to represent.
i) Possible states of nature are publicly known ii) Probabilities of states are objective How does ERC differ wrt firms’ fundamental charecteristics? – High Beta, Low ERC Governance role of Financial Reporting: Emphasizes the use of acc info to eval
LECTURE 3: IDEAL CONDITIONS:
and publicly known iii) Ex-post realization of the state is publicly observable iv) Disc as high risk firms increase the risk of investment portfolio. High Leverage Ratio, Low managers.Focuses on how acc info may be useful in assessing whether managers have
rates are known (i.e. fixed interest rates) v) cash flows are known conditional on the ERC as high leverage increases default risk. High g, High ERC as higher g means fulfilled the stewardship responsibility to investors. It is closely linked to the objective
Semi-strong form: Incorporates all publicly available information. An efficient
states of nature in the scenario of “with uncertainty”, and there is still no information future earning capacity is high. of corp gov in aligning the int between managers & inv.
securities market is one where the prices of securities traded at all times fully reflect all
asymmetry. How does ERC differ wrt firms’ earning quality? –Higher the earning persistence, Meaning of efficient contracting: in the efficient contracting, firm is views as a
information that is publicly known about those securities.
How to calculate? i) Assets/Liabilities: PV of future CFs ii) Realized NI= E(NI) + Higher the ERC because high earnings today are going to stay. Higher the accrual series of efficient contracts. It minimizes A) Cost of monitoring B) Cost of
Strong form: All info, incl inside info are priced in.
Abnormal Earning iii) Expected income= Opening balance of SE * Interest rate quality, higher the ERC as more info transparency. Example: If earning goes up by 1$ renegotitation by having built-in flexibility for unexpected return C) Moral hazard
Concepts of market efficiency: i) Markets are quick and efficient processors of info.
iv) Abnormal Earnings= Actual realized CFs – E(CFs) v) Expected CFs is the avg and and is expected to go up by 1$ each year with 10% interest, then the share price problems aka agency probs. It is used to allign the interests of various parties. It is a
ii) It can be visualized as individuals continuously revising their probabilities as
CFs across different states of nature goes up by 1+1/0.1= 11$ and the ERC is 11. This is if accounting rules only allow way to enhance corp gov. Various parties incl all stakeholders.
new information comes in from any source. iii) Individual errors cancel out provided
CHARECTERISTICS OF FINANCIAL STATEMENTS UNDER IDEAL recognition of 1$ today. Real life example of efficient contracting: Companies may give dealers discretion
that there is no systematic bias.
CONDITIONS How does ERC differ wrt investors’ heterogeneity?- Higher the inv heterogeneity, over when to lower prices of cars to boost sales. This leads to more flexibility and in
RISK:
i) FS are relevant and reliable: Acc info reflects the firm’s future performance & lower the ERC as different investor’s reaction cancel out and avg reaction is muted. turn leads to more efficiency in the sense thart dealers can react quickly to local
Types: Idiosyncratic, diversifiable risk- firm specific or industry specific factors OR
nobody can lie about it as they have the same info. ii) NI has no info content beyond IMPLICATIONS OF VALUE RELEVANCE RESEARCH: i) Need to separate the conditions. But , downside is that dealer may abuse.
Systematic, non diversifiable risk- market-wide factors (eg. Macro).
B/S: Everyone can calc it based on SE & Int rate. iii) PV (VIU) = MV (FV): everyone one off items in the FS from the continuing items. It might be that a lot of these are Efficient Contracting and Accounting: Assume that 10% of AR is mandated to be
EXPECTED RETURN = CAPM DERIVED
gets the same number. included in the income from continuing operations. Ex: Restruc, GW impair. ii) Need provisions. This is not efficient contracting as most companies would be above or
E(Rjt) = (E(Pjt + Djt) / Pjt-1) – 1. In an efficient market where prices reflect all the
1) Lack of ideal conditions leads to incomplete markets. Reason for to disclose more info about the g opportunities in MD&A section. below this level. It would also not allow managers to adjust in changing
publicly available info, he E(R) under CAPM equals the equation before. There is no
incompleteness: i) Thin Markets ii) Info asymmetry. Significance of incomplete VALUATION APPROCH TO DECISION USEFULNESS: Normally, the decision circumstances. Thus, we need judgement. BUT flexibility would lead to manager’s
arb opportunity. Investors at max earn the expected return.
markets: i) Cannot always use MV as a proxy of PV ii) If there is no MV, est PV. usefulness (i.e. the information role of FS) does not have to be directly about value. It opportunistic behavior (eg: Discretionary accruals). This leads to managers resisting
EXAMPLE: Suppose CAPM Return is 5.4% and the stock price is $10. Now suppose a
Conclusion: If everyone has to estimate PV, everyone’s PV of asset & NI is diff. just provides information that assists in predicting value. However, the valuation or caring about changes in flexibility caused by policies.
firm specific news leads to investors expecting the share price to become $11. The
2) Lack of ideal conditions means that estimates are needed to apply PV Acc: approach to it means undertake a responsibility to incorporate current values into the Economic consequence of accounting standard: Economic consequences of
expected return would still be 5.4%. WHY? Cus CAPM would not change with firm
Future state realizations may not be currently known leading to need for estimates financial statements proper, providing that this can be done with reasonable reliability, accounting standards is the impact of accounting standards on the decision-making
specific news. The new stock price would be (11-x)/x=0.054. We have now
of quantities/of future sales and purchases and timing of future transactions. You thereby recognizing an increased obligation to provide investors with up-to-date behavior of firms. Accounting standard affect manager behavior.
established a link between information (through its impact on expectations) and
would also need to estimate probabilities of future state realizations and estimates are information. Two types: 1) Exit price (fair value): Fair value is the price that would be ESO (an example of manager resistence on change in policies): Previously, no
price movements. In this case, the firm-specific release changes investors’
subject to bias and error. received to sell an asset or paid to transfer a liability in an orderly transaction between expenses was needed to be recorded if the intrinsic value of the ESO was 0. Note that
expectation of the future price. Since the expected return of the firm does not
RESERVE RECOGNITION ACCOUNTING: market participants at the measurement date. 2) Value-in-use: Discounted present this has no effect on CFs but still expensing off the FV of ESOs was met with huge
change, the current price changes. Thus, the release affects the current price
It is an application of the PV accounting when ideal conditions do not exist. It is value of cash expected to be received or paid with respect to the use of the asset or backlash from managers. Increasing evidence of abuses of ESOs led to renewed
through its impact on expectation of the future price.
applies to proved reserves only. The CFs have to be discounted at 10%. Revenues liability. pressures to expense ESOs, despite strong manager resistance.
IF ONE FINDS A 10 $ BILL FALLEN:
are recognized as reserves are proved. This method uses past year’s oil and gas Why is it imp? I) Securities markets may not be as efficient as previously believed. If Positive Accounting Theory (PAT): To understand economic consequence of acc
Crude version would argue that if it was really a 10$ bill, it would have been taken by
prices. markets are not fully efficient, decision usefulness is not sufficient and the standards, we need a theory to explain managers’ behavior and predict managers’
now and that it is impossible.
Critiques of Reserve Recognition Accounting: i) Past year prices may not be good valuation approach is needed. II) Ohlson’s clean surplus model: This is a accounting choices. i.e. why do managers care about acc policies?
Theory attempts to predict how managers will max their own interests or firm’s lead ID is avail to SH when they have concerns for which contact through normal Principle 7 related to compensation: The level and structure of remuneration of the Create an information system to capture and report on the organization’s risk-
interest relative to the firm’s compensation contracts, debt contracts, and political channels of communication with the chairman or the mgmt are inappropriate or Board and key management personnel are appropriate and proportionate to the management process.
costs based on acc variables. It supports the gov role of fin rep. inadequate. sustained performance and value creation of the company, taking into account the viii) Monitoring: Review data from the information system and take actions.
2 Views of PAT: 1) Efficient contracting view: Managers want to choose accounting Board Communities: A) Nominating Committee is in charge of leading the CEO strategic objectives of the company. The performance should be measurable, apt & Risk Culture: The values, beliefs, knowledge, attitudes and understanding about risk
policies to attain corp governance objectives of the firm. 2) Opportunistic View: succession-planning process. Ensure that formal and transparent process for the meaningful. RCs should also consider implementing schemes to encourage NEDs to shared by employees. It sets the tone for risk tolerance in the organization and ensures
Allowing flexibility will lead to opportunistic behavior. Managers would choose acc appointment and re-appointment of directors, taking into account the need for hold shares in the company so as to better align the interests of such NEDs with that risk consideration is a key part of all decisions. What determines risk culture? 
policies for their own benefit at the exp of shares. progressive renewal of the Board. The NC also ensures that i) new directors are aware interest of shareholders. However, they should not be overcompensated so that Strong leadership, clear parameters surrounding corporate risk taking, and access to
3 Hypos of PAT when managers choose acc policies in their own best interests : A) of the roles , ii) adequate carrying out of duties , iii) company discloses the independence is not harmed. They should also consider the use of contractual information about potential risks are necessary for this to occur. What contributes to
Bonus hypo: bonus based on acc variables. Implied gov role for reporting. B) Debt directorships and principal commitments of eaach director and where director holds provisions to allow them to reclaim their incentive components of remuneration risk attitude?  Risk info & Reporting, Leadership and Processes, controls &
Convenant hypo: Debt convenants based on acc variables. C) Political cost Hypo: significant number of directorships. from executive directors and KMP in exceptional circumstances incl misstatements, Systems. What contributes to risk awareness?  controls & Systems, Governance,
High profits may create political heat. B) Remuneration Committee is responsible for setting the compensation of the misconduct resulting in loss. Risk strat.
Managing reported earnings through accruals: Examples of discretionary accruals CEO and for advising the CEO on the compensation of other senior executives. C) Principle 8 related to compensation: The company is transparent on its Principle 9: BOD ensures that mgmt maintains a sound system of risk management
are the discretionary components of i) allowance of doubtful debt, warranty provisions, Audit Committee is responsible for overseeing the company’s external audit and is remuneration policies, level and mix of remuneration, the procedure for setting and internal controls, to safeguard the interests of the company and its shareholders.
and provisions for reorganizing, layoffs, restructuring, etc. Note that discretionary the primary contact between the auditor and the company. D) Risk Committee is remuneration, and the relationships between remuneration, performance and value The Board sets up a Board Risk Committee to determines the nature and extent of
accruals are not directly observable by investors. responsible for monitoring the company’s risk management framework and creation. The firm discloses in its annual report the policy and criteria of setting the significant risks which the company is willing to take in achieving its strategic
LECTURE 6: CORPORATE GOVERNANCE & BOARD STRUCTURES: policies. remuneration as well as names, amounts & breakdown of salaries of: i) each individual objectives and value creation. The BOD discloses in annual report that it has rceeived
What is corporate governance?--> Corporate governance' includes every force that Board Performance: The company has to undertake annual assessment of its director & CEO ; ii) at least the top five key management personnel (who are not assurances from from i) the CEO, CFO that the financial records have been properly
bears on the decision-making of the firm. That would encompass control rights of effectiveness as a whole, and that each of its board members and committees. They directors or the CEO) in bands no wider than S$250,000 and in aggregate the total maintained and it give a true and fair view of the company’s operations and finances ii)
(shareholders contractual covenants, insolvency powers of debt holders, commitments have to say how they evaluated and identify the external facilitator and its connection, remuneration paid to these key management personnel. CEO and other key management personnel who are responsible, regarding the
entered into with employees, customers and suppliers, the regulations by governmental if any, with the board. The company discloses the names and remuneration of employees who are
agencies, and the statutes by parliamentary bodies. Decisions are impacted by LECTURE 7: AGENCY CONFLICTS AND EXECUTIVE REMUNERATIONS: substantial shareholders of the company, or are immediate family members of a adequacy and effectiveness of the company’s risk management and ICs.
compeition and society Non Coorporative Game Theory: What is game theory?: an economic director, the CEO or a substantial shareholder of the company, and whose Risk Analysis Techniques: i) Risk Mapping: It involves the construction of a
Why is it imp? A) Improve decision making and controls at board level (even when representationof decision-making involving two or more players. What are its key remuneration exceeds S$100,000 during the year, in bands no wider than matrix, and placing each risk in the matrix according to the likelihood or
mgmt is responsible for day to day, board guides and decides policies on risk, corp features? i) Two or more parties are in conflict ii) Strategies / payoffs for each players S$100,000, in its annual report. probability of a risk event (frequency of risk) and the impact of a risk event (severity
objectives, and senior remuneration). B) safeguarding shareholder int (protect firm are known iii) predict outcomes based on certain assumptions about wealth maximising The company discloses in its report all forms of remuneration and other payments of risk). This profile of risks in a severity/frequency matrix can subsequently be used
assets from abuse of power). C) Increase firm value (create value for all shareholder behavior iv) Nash Equilibrum: make decisions conditional on other players actions. and benefits, paid by the company and its subsidiaries to directors and key to set priorities for risk control. Risks with biggest probability of happening and the
incl the minority ones. D) Attract more future shareholders (Future shareholders Usually not the best. management personnel of the company. It discloses details of employee share most severe consequences that fall outside the risk tolerance range or limit should
trust the management.) Non Coorporative Game Theory- Implication for Accounting: Accounting schemes. be given priority for management action.
Is corp govt different across the world? A) Depends on whether there is a majority choices: Managers: Make the choice to maximise their ability ; Owners: Factor LECTURE 7: EARNINGS MANAGEMENT:
stakeholder. In US & UK, no majority shareholder and directors and professional managers’ decision when making investment decision. Negative aspects of non- Definition: Earnings management is the choice (related to accounting policies or
managers are agents for shareholders. In Asia, many companies are either state-owned coorporation: i) Everybody is worse off and ii) worse, the markets break down. accruals) made by a manager that affects earnings so as to achieve some specific
or family owned leading to conflict between maj & min shareholders. B) Rule- How can the managers and owners coorporate and get a better result?  They can reported earnings objective. This definition can encompass “real” earnings
based/Principle-based gov: Rule based relies more on law to establish a corp gov pursue a particular action. But the problem with this is that the commitment might not management, accomplished by timing investment decisions to alter reported earnings
framework and principle based is a voluntary corp gov code (eg. Singapore code of be very credible. Mechanism to help managers to work hard and report or some of it.
corp gov). For each principle, there is a guideline on how to follow. Need to comply “truthfully”: i) Regulators- to reduce potential abuse of accounting choices ; ii) How to manage earnings?: IS: Revenue recognition, allowance for doubtful debts,
or explain non-compliance. Corporate Governance ; iii) Audit: to increase the credibility of reporting. All of these warranty provisions, capitalization. BS: Off-BS items. Real transaction management:
Purpose of Singapore Code of Corp Gov: A) Should create effective BOD who come with a cost. Therefore, we can design a contract to motivate behavior. Investment policy, R&D spending, marketing spending, sale timing
know their roles. B) Formal and transparent process for BOD election. C) Agency Theory Fundamentals: all parties are self-interested and expect other Why do firms manage earning?: i) Capital Mkt moves (eg premium for meeting
Accountability and audit should be there. D) Suitable level of comms should be there parties to act similarly. In this, parties contract to get better results than non- analyst expectations) or ii) Contractive incent: Convenant Hypo & Compensation
between the company and its shareholders. Principles are grouped in 4 broad coorporative game. This addresses the moral hazard problem as agents are effort and contracts
categories: board matters, remuner, acc&audit, rights & respons. risk averse. Bhojraj (Meeting earning targets): evidence that firms that miss analysts’ ii) Probability Estimates and Analysis: Probability analysis calculates an expected
Role of Board: Prov 1: Company is headed by effective BOD that works with mgmt a cost. Therefore, we can design a contract to motivate behavior. expectations with high earnings quality generally outperform firms that beat analysts’ value of loss or an expected value of the outcome. An expected value (EV) is
for LT success. Prov 1.1: They must act in the best int of the company and hold mgmt Agency Theory- Types of Contracts- i) Direct Monitoring: Fixed salary with simply a weighted average value, where possible outcomes are weighted according to
responsible for performance. They put in place the code of conduct and sets the tone penalty for shirking. Manager bears no risk and it is impossible to achieve unless in expectations with low earnings. These findings are consistent with firms making the probability that they will happen. May arise in industries or companies that have
from top and desired organisational structure, and ensures proper accountability. ideal conditions. Ii) Indirect Monitoring: Impute manager expectation from payoff. myopic short-term decisions to beat analysts’ earnings forecasts at the expense of long- large quantities of historical data for both the severity of losses and the probabilities
Directors facing conflict recuse themselves from discussions regarding the conflict. Owner cannot be certain whether the payoff is due to low manager effort or unfortunate term performance. of losses. Example: Expected value of loss= Size of debt * Loss given default (as a %
Prov 1.3: It decides on the matter that requires its approval and communicates this to realization of firm risk. iii) Rental Agreement: Inefficient because agent bears all risk Convenant Hypothesis: Treatment firms adopted income-increasing accounting of the debt) *Probability of default.Scenario Planning & Stress Testing : A method of
the mgmt in writing. These matter incl: div policies, strategic plans,issue of shares, fin iv) Profit sharing or incentive based compensation: Need a measure of performance. changes in the years leading to default. Treatment group: Firms that had defaulted on looking into the future when there is a great deal of uncertainty about what may
results, opr plan,etc. Prov 1.5: Director’s attendance and no. of meeting are disclosed in Agency Theory- The Model- Principal and agents are rational. Principal is assumed to public/pvt debt. Research question: Do firms manipulate earnings to avoid violating happen. Stress testing is similar to scenario planning, in the sense that it tests a
ann report. Directors on multiple boards have to give sufficient time to each. 4be risk-neutral for simplicity. Agent is risk and effort averse (more effort  greater covenants in debt contracts? number of future outcomes given a situation in which one or more extreme conditions
Size and composition of board: Prov 2.4: BOD should have apt size and apt balance disutility). Owner’s problem: Manager compensation=. Salary + k * net income. Bonus Plan Hypothesis: Evidence of upward earnings management when net income apply. Ex: banks
and mix of skill, knowledge, experience and diversity so as to avoid group think and Find k to maximise the owner’s utility. Subject to induce managers’ effort and between bogey and cap. Healy used total accruals as a proxy. Root Cause Analysis: An approach to identifying and assessing the fundamental
foster healthy debates. Policies and progress regarind this should be incl in annual manager receives the reservation utility. Reservation utility is the manager’s Bad Side of Earnings Mgmt: i) Reduces the reliability and information usefulness of cause of a problem or a risk. A problem is often identified by its symptoms or effects,
report. opportunity cost, the utility can be obtained by the manager is an alternative accounting reports. ii) Can lead to earnings restatements iii) Lower credibility rather than by its cause. To discover the cause of a problem, it is necessary to 'dig
Board independence: Non-exec directors & independent directors led by independent employement opportunity. among investors iv) Higher cost of obtaining capital (equity or debt) down' and look more deeply into the matter. Ex: “Five Whys Technique”: Find a prob
chairman meets regularly without presence of mgmt. The chairman of such meeting The Good Side of Earnings Management: i) To credibly communicate inside info and start with the main question. Then the ans to that becomes the next Why Question.
provides feedback to the board and/or chairman. Exec Directors are senior execs of the to investors. (To solve blocked communication where managers have private LECTURE 9: INTERNAL CONROLS:
company who are part of the board. Non Exec Directors is a part of the board but does information and is costly to communicate it investors directly) ii) Contract violation What is internal control? Internal control is a procedure or arrangement that is
not have exec responsibilities. Not a full-time employee. Independent directors are is costly, earnings management may be low-cost way to work around (if a firm is just intended to: i) Prevent an operational error, disruption, or failure ii) Reduce the
NEDs who are deemed independent of the board. Functions of NEDs: i) To make suffering from short-term financial distress but not economic distress. AND it gives risk that such an error, disruption or failure might occur iii) Detect a failure when
constructive challenges and help develop proposals on board strat ; ii) to review the SUPPOSE Her utility is equal to the square root of the amount of money received. If
she works hard, her effort disutility is 2. If she shirks, her effort disutility is 1. she is flexibility to react to unexpected state realizations when contracts are rigid and it does occur (and initiate control action). Is there a diff btw risk mgmt and ICs?
performance of mgmt in meeting their agreed goals, and also monitoring the the incomplete). Risk management refers to the identification, measurement, assessment, and
reporting of performance by mgmt. NEDs arguably have a diff tasks they have to willing to accept the manager position but that she must receive at least an expected
utility of 12, or she would be better off to work somewhere else. TAKEAWAYS: Managers may choose policies to achieve certain objectives. (Efficient monitoring of risk. Internal controls refers to the measures implemented by
be the colleagues of exec directors in developing strat but also monitor them and Contracting vs. Opportunism)--- The resulted net income number is the product of management to mitigate risks. Why do we need it? To prevent and detect fraud ;
challenge their managerial performance. To ensure Marie takes up the contract:
trading-off the different objectives. STRONG Internal Controls  less Ensure accuracy and completeness of accounting information ; Ensure timely
Board Expertise and Diversity: The board should consist of people who collectively
have apt balance & diversity of skills, exp, gender and knowledge. These skills should
consist of core-competencies duch as acc&fin, ind knowledge, strat planning and
E U m ( a1 ) =0.7 √ 10,000 x +0.3 √ 1,600 x−2 manipulation.
LECTURE 8: RISKS
preparation of financial reports ; To ensure that business operations are conducted in an
efficient manner ; To ensure compliance with regulations and laws ; To safeguard
What is risk? 2 key ideas: Uncertainty & Outcome. People usually associate risks with company assets
experience, biz or mgmt exp, etc.
Board Balance and Independence: Prin 2: Board should have an apt level of 12=0.7× 100 √ x +0.3 × 40 √ x−2; ;; ; ; 14=70 √ x +12 √ x -ve outcomes but it has both. Ex: A jaywalker’s objectives: i) Cross to save time (+ve
outcome) and ii) Cross without getting hit by car (-ve outcome). Risks are the
Financial Risks: Failure to receive income that is due ; Misappropriation of assets ;
Deterioration in the value of assets due to poor maintenance ; Transactions being

√ x=14 /82 √ x=.1707 x=.0291

independence and diversity of thought and background for the best int of company. consequences of an event and the associated likelihood of that event. completed without adequate authorization ; Inadequate value being received in
Prov 2.1: An independent director is one who is independent in conduct, character External Risk: Related to business environment (Ex: int rates, expansion in new mkt, exchange for payments made ; Deterioration in relationships with customers and
and judgement, and has no relationship with the company or related ops and major etc) Internal Risk: Risks related to within organisation (ex: Fraud, data leak, harrass)
To ensure that Marie would not shirk with this profit level, 𝐸𝑈_𝑚 suppliers ; Failure to record A/L adequately. Controls: Segregation of duties to
shareholders (>5% voting rights) or its officers. Prov 2.2: Independent director Categories of business risk: i) Strategic risk: Arises in the business environment. Ex: reduce fraud and increase checks ; Full documentation of assets, liabilities, and
make most of the board where chairman is not independent. Prov 2.3: NEDs make (𝑎_2)=0.3√(.0291×10,000)+0.7√(.0291×1,600)−1 = 5.1176+4.7764−1=8.8940<12
Agency Throry Implications: i) Compensation= Salary + incentive. The key is the New tech, customer taste, govt regulations, state of eco, competitior’s action ii) transactions ; Matching of source documents and accounting records ;
most of the board. Operational Risk: Risk of loss from a failure of internal business processes and Reconciliation of information from different source documents ; Completeness
A Director is deemed to be non-independent when: i) if the director was employed performance measure- the stewardship role of accounting information. ii) Pros: Work
hard to improve firm performance and therefore the stock price and NI iii) Cons: internal controls. Ex: IT failure, loss of key employees and customers., fraud, supply checks over documents and accounting entries ; Physical security controls over
by the company or any related corporations since 3 financial yrs ; ii) has an chain and ops interruption iii) Financial Risk: Affects firm’s financial performace, assets ; Authorization of payments and customer and supplier terms by senior staff ;
immediate fam member who was employed in the last 3 fin years been employed by Earnings Management & Pay Risk Premium.
Desirable properties of the benchmark: Senstivity: How sensitive is the measure wrt value, liquidity, etc. Ex: Changing int rates (external), Errors in published FS (internal), Regular reviews of assets held ; Re-performance of calculations ; Confirmation of
the company.or related corps whose remuneration is dependant on the remuneration Credit risk (internal). iv) Compliance Risk: Failure to comply with laws, regulations, information by suppliers, customers, and bank
committee. ; iii) has been in the board for agg period of 9 yrs and whose manager performance.(changes in performance due to effort) Precision: Less noise in
the measure. (reciprocal of variance of the performance measure). Accounting codes of conducts, or standards of practice. It has fin, reputational and business impact. Operational Risks: Assets, resources, and facilities not available when required
reappointment as an independent director is not sought and approved by a) all Risk Management: Risk management is the process by which a company evaluates Assets, resources, and staff not utilized efficiently ; Sales are lost because of
shareholders and b) all shareholders excluding shareholders who also serve as directors Earnings vs stock price: i) It is a tradeoff between senstivity and precision ; ii)
Manager’s decision horizon. While is stock price is more sensitive to the manager’s and reduces its risk exposure. It includes the policies, actions, and procedures that operational difficulties or by failures to respond to customer complaints ; Employees
or CEOs. management implement to increase the likelihood and benefit of positive outcomes make mistakes ; Machines break down ; IT system failures ; Faulty products ; Business
Roles of CEO and Chairman: Princi 3: There is a clear division of responsibilities in efforts because manager’s efforts are not included in the net income (example: apex,
R&D, etc are also expensed), it is less precise as it is affected by macro & non- and minimize the likelihood and severity of negative outcomes. Why is it imp?  interrupted by external events Controls: Regular review of resources and assets to
the role of the leader of mgmt and board, and no one individual has unfettered power of Helps management deal effectively with potential events that create uncertainty and ensure they are available, adequate, and have not been misappropriated ; Quality
decision-making. The chairman is the head of board and the CEO is the head of the manager factors.
Principle 6 related to compensation: Says that BOD has to have a formal & can be value-destroying. Zero risk is not the aim as high risk  high return. checks on resources and products ; Monitoring of staff performance and time spent
mgmt that takes care of company ops. CEO makes strat proposals to board, proposes COSO Framework: i) Internal environment: Establish the company’s philosophy on tasks ; Procedures such as competitive tendering and review of alternative supply
the annual and capital budget to the board, implements strat as decided by the board, transparent procedure for developing executive remuneration. No director should be
involved in deciding his or her own remuneration. The board makes the toward risk management and risk philosophy ii) Objective setting: Evaluate the sources to ensure resources are obtained at a reasonable price and quality ; Planning
accountable to the BOD for perfo. Chairman should lead the BOD to ensure its company’s strategy and set organizational goals based on the risk tolerance of and forecasting procedures ; Comparison of actual results with plans ; Regular
effectiveness on all aspects of its roles: i) ensuring that they receive complete, adequate remuneration committee to recommend i) a framework of remuneration for the Board
and key management personnel; and ii) specific remuneration packages for each management and the board iii) Event identification: Examine the risks associated with reports to senior management ; Security procedures for safeguarding assets ;
and timely info for meetings, ii) ensure sufficient time is there for all agendas to be Contingency plans and resources being available if the organization suffers serious
covered, iii) promote a culture of openness and debate, iv) to faciliate the contributions director as well as for the key management personnel. The RC should comprise of at
least 3 directors. All members of RC are non-executive directors, the majority of each potential business opportunity iv) Risk assessment: Determine the likelihood disruption
of all individual director discussions at board meetings- in particular NEDs. Internal Control and Audit in Corporate Governance: Audit Committee takes
Prov 3.1: Chairman and CEO are separate people to ensure bal of power, increased whom, including the RC chairman are independent. The company discloses the and severity of each risk. v) Risk response: Identify the actions taken to prevent or
engagement of any remuneration consultants and their independence in the deal with each risk. vi) Control activities: Establish policies and procedures to ensure care of these things. It has responsibility for both external audit and ICs. They review
accountability & greater capacity of the board to make independent decisions. Prov i) significant financial reporting issues and judgement ii) internal control and risk
3.2: When chairman is conflicted and not independent, the board has a lead ID. The company’s annual report. that risk responses are carried out as planned. vii) Information and communication:
management systems iii) the adequacy of the external audit and the company’s
internal audit function iv) whistle-blowing policy and procedures & also Make
recommendations to the Board on external auditors
COMPOSITION OF AUDIT COMMITTEES: Comprises of 3 directors, all of
whom are non-execs and majority of whom, incl AC Chairman are independent. At
least 2 members incl AC Chairman should have recent and relevant acc & fin

experience. The AC does not comprise former partners or directors of the

company’s existing auditing firm or auditing corporation: (a) within a period of
two years commencing on the date of their ceasing to be a partner of the auditing firm
or director of the auditing corporation; and in any case, (b) for as long as they have any
financial interest in the auditing firm or auditing corporation.
ADDITIONAL NOTES: GAME THEORY: The manager may exploit this advantage by not revealing all the information that the investor
desires. The investor looks to the firm’s financial statements to reduce this source of information asymmetry.The investor, being aware of these
possibilities, will take them into account when mak-ing an investment decision. The manager, in turn, will be aware of possible investor reaction

when preparing the financial statements. We model this situation as a non-cooperative game since it is difficult to envisage a binding contract
between manager and investor about what specific information is to be supplied. Such an agreement could be very costly, since similar contracts
would have to be negotiated with all potential investors. But different investors have varied decision problems and, hence, different information
needs, so that many different contracts would be needed. Even if such binding agreements were made, they would be difficult and costly to
enforce, because each user would need to conduct, or hire, an audit investigation of the firm to monitor management compliance with the
contract. In other contexts, binding agreements may be illegal, as when an oligopolistic industry enters into an agreement in restraint of trade.
They are non-cooperative in that the two parties do not specifically agree on actions; rather, the contract motivates actions by rational and self-
interested parties. Nevertheless, each party must be able to commit to the contract—that is, to bind themselves to cooperate, or to “play by the
rules.” DIRECT MONITORING: If the owner could costlessly observe the manager’s effort, this would solve the problem. If the owner could

costlessly observe the manager’s effort, this would solve the problem. The first-best contract also has desirable risk-sharing properties. Note that
under this contract the manager bears none of the firm’s risk, because the salary is fixed, regardless of the payoff. Since the manager is risk-
averse, this is desirable. The owner bears all the risk of the random payoff, but is risk-neutral, so does not mind. Indeed, we could argue that a
function of business ownership is to bear risk. Further, consider that “the owner” in this model may represent shareholders who hold diversified
portfolios. In this case, the risk of any single firm is not a concern—it will be diversified away. Unfortunately, the first-best contract is frequently
unattainable. This would seem to be the case in an owner-manager contract, because it is unlikely that the owner could monitor the agent’s effort
in a managerial setting. The nature of managerial effort is so complex that it would be effectively impossible for a remote owner to establish
whether the manager was in fact “working hard.” INDIRECT MONITORING: Unfortunately, the first-best contract is frequently unattainable.
This would seem to
be the case in an owner-manager contract, because it is unlikely that the owner could monitor the agent’s effort in a managerial setting. The nature
of managerial effort is so complex that it would be effectively impossible for a remote owner to establish whether the manager was in fact
“working hard.” . In agency theory, this is called moving support—that is, the set of possible payoffs is different (it moves) depending on which
act is taken. n real-world contracting, generally, we cannot rely on indirect monitoring to attain the first-best contract. For example, in many cases
the payoff may be any positive or nega-tive number. If the payoff is, say, a loss of $1 million, the owner cannot be certain whether this loss
resulted from low manager effort or an unfortunate realization of the firm’s risk. In addition, legal and institutional factors may prevent the owner
from penalizing the manager sufficiently to force. RENTAL AGREEMENT: At this point, the owner may well be tempted to say to the manager,
“Okay, I give up—you take the firm and run it, taking 100 percent of the profits after paying me a fixed rental of $51.” Then, the owner no longer
cares what action the manager takes, since the owner receives a rental of $51 regardless. Consequently, the owner is worse off. The reason is that
this contracting arrangement has inefficient risk-sharing characteristics. The owner is risk-neutral, and hence, is willing to bear risk, but the fixed
rent does not involve risk for the owner. The risk-averse manager, who dislikes risk, is forced to bear all the risk. The owner must lower the rent
from $57 to $51 so that the manager can receive reservation utility of 3. The difference of $6 is called an agency cost, a component of contracting
costs, which the owner will want to minimize. PROFIT SHARING: Finally, we come to what is often the most efficient alternative if the first-best
contract is not attainable. This is for the owner to give the manager a share of firm performance. However, the owner immediately runs into a
problem. The payoff is not fully observable until next period. Yet the manager must be compensated at the end of the current period.
Unfortunately, net income is not fully informative about effort. One reason is poor cor-porate governance, such as weak internal controls, which
allow random error or bias into net income.