Final Paper - Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla,

•Market efficiency relies on rational investors.   On an individual basis, lots of evidence that  people aren’t rational: –People take credit for their successes, blame  nature for failures.  So if stocks go up, people feel  they’re smart, buy more, causing momentum.   However, they don’t want to sell losers, resulting  in underreactions….

–Prospect Theory  Prospect Theory •People are loss‐averters, so they will hang on  to losers and sell winners •Individuals also tend to overweight salient,  anecdotal and extreme evidence  –Underestimate probabilities of likely states –Overestimate probabilities of unlikely states What Is the Measurement  Approach? •Greater use of current values in the financial  statements proper •Recall two versions of current value –Fair value: exit price –Va l u e‐in‐use: present value of future cash receipts  or payments •Goal of measurement approach is to increase  decision usefulness by increasing financial  statement relevance Why the Measurement Approach? •Decision Usefulness Perspective tells us  whether information released has an  influence on decisions (presumably because it  changed users’ assessment of firm value) BUT: •It does NOT tell us whether the original or revised  assessments of firm value are reasonable So, our next question is: •What is the relationship between accounting valuation  (particularly the balance sheet) and market valuation  and can we strengthen that relationship?  Why Are Accountants Moving  To w a r d s a Measurement  Approach? •To extent  average investor not fully rational  and securities markets not fully efficient, a  measurement perspective may improve  decision‐making and market efficiency –The greater relevance of current values may  enable ordinary investors to improve their  decision making –This assumes that the increased relevance is not  outweighed by lower reliability Why Are Accountants Moving  To w a r d s a Measurement  Approach? •Empirical evidence that net income explains  very little share price variation (i.e., net  income has a low “market share” in terms of  information that drives the market). Lev  (1989), Section 6.9 •Better measurement (eg. fair value  measurement?) may increase accounting  “market share” in explaining share price  changes. Why Are Accountants Moving  To w a r d s a Measurement  Approach? •Ohlsön’s clean surplus theory –A theoretical framework supportive of a  measurement approach •Auditor Liability –Better measurement may reduce auditor liability  when firms become financially distressed Measurement Approach •Accounting should help users value investment  alternatives –De we provide info about risk, future cash flows? Even if  we do, can investors calculate value themselves? •Standard setters currently face many challenges  related to valuation –Intangibles in new economy? Financial instruments? •Accountants are under increasing pressure to ensure  that financial statements are relevant to investors –More litigation –Higher public expectations –Many highly publicized business failures In Class Discussion •Chapter 6 Textbook Question 1 •Why does a measurement approach to  decision usefulness suggest more value  relevant information in the financial  statements proper, when efficient securities  market theory implies that financial statement  notes or other disclosure would be just as  useful?   Auditor Liability •Will a measurement approach reduce auditor  liability? –Perhaps •Auditor can claim that the financial statements proper  anticipated value changes, rather than buried in  supplemental information or not disclosed at all •But, current values may be subject to manager  bias if no market value available (incomplete  markets) •Then, may be hard for auditor to resist manager bias Auditor Liability and Conservative  Accounting Example –A change in asset value has already occurred –Assume investor is risk averse –Investor opportunity loss of expected utility if a  decline in asset value is not recorded = 1.02 –Investor opportunity loss if an increase in asset  value not recorded = .52 –Then, investor more likely to sue auditor  if a  decline in asset value not recorded.

–Auditor reaction: impairment tests, to reduce  likelihood  a decline in asset value is unrecorded,  thereby reducing likelihood of lawsuit In Class Discussion  •Chapter 6 Textbook Question 4 •Explain in your own words what "post  announcement drift" is. Why is this an  anomaly for securities market efficiency? Give  two behavioral biases that could generate  post announcement drift.   Measurement Approach •Accounting should help users value investment  alternatives –De we provide info about risk, future cash flows? Even if  we do, can investors calculate value themselves? •Standard setters currently face many challenges  related to valuation –Intangibles in new economy? Financial instruments? •Accountants are under increasing pressure to ensure  that financial statements are relevant to investors –More litigation –Higher public expectations –Many highly publicized business failures Conclusions on Measurement  Approach •Assuming reasonable reliability, current value  accounting can increase decision usefulness relative  to historical cost accounting •Increased use of current value accounting (including  impairment tests) in financial reporting because:  •Markets not fully efficient •Low explanatory power of net income for share returns •Ohlsön clean surplus theory •Auditor liability •Decision usefulness for investors may be further  increased by conservative accounting   Chapter 6 –Question for  Discussion •The 2007 – 2008 meltdown of the market for  asset‐backed securities is often blamed on lax  mortgage lending practice, poor risk controls  by financial firms, greedy managers, and  inadequate regulation. However, the  meltdown also has important implications for  financial accounting and reporting practice.   Give two such implications and, for each  one,  explain why accountants should be aware of it  and take is seriously.  (Hint: see also Chapter 1  –Section 1.3) Copyright © 2015 Pearson Canada Inc. Chapter 7 7 - 1 Copyright © 2015 Pearson Canada Inc.7 - 2 Current Value Accounting •Value-in-use –Also called amortized cost –Valued at discounted present value of future receipts –Relevance: high –Reliability: •Error and possible bias in estimating •Management may opportunistically change intended use to increase present value or avoid impairment writedown >> Continued Copyright © 2015 Pearson Canada Inc. Current Value Accounting (continued) •Fair value –Definition under IFRS 13 •The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date –Also called exit price –Exit price measures opportunity cost of retaining asset/liability in firm •Hence a stewardship aspect in addition to valuation aspect.

•If manager cannot earn at least cost of capital on asset, should be sold >> Continued 7 - 3 Copyright © 2015 Pearson Canada Inc. Current Value Accounting (continued) •Market price does not exist for many assets –Fair value hierarchy; IFRS 13, ASC 820-10 •Level 1: market price exists •Level 2: market price of similar asset exists •Level 3: no market price, fair value must be estimated –Effect on reliability as move from level 1 to levels 2 and 3? >> Continued 7 - 4 Copyright © 2015 Pearson Canada Inc.7 - 5 Examples of Current Value Accounting •Accounts receivable and payable –Approximates value-in-use if time is short •Lower-of-cost-or-market rule –E.g., inventories –Rule is example of conservativism, also a partial application of current value accounting >> Continued Copyright © 2015 Pearson Canada Inc. Examples of Current Value Accounting (continued) •Revaluation option for property, plant & equipment, IAS 16 –Option to value at fair value –Not available under FASB standards •Impairment tests –E.g., property, plant & equipment •Valued at recoverable amount if less than book value •An example of conservatism, also a partial application of current value accounting 7 - 6 Copyright © 2015 Pearson Canada Inc.7 - 7 Financial Instruments •Definition –A contract that creates a financial asset of one firm and a financial liability or equity instrument of another firm •Note broad definition of financial assets and liabilities •Includes both primary and derivative financial instruments Copyright © 2015 Pearson Canada Inc.7 - 8 Financial Instruments •IFRS 9 •Financial assets and liabilities recorded at fair value at acquisition •After acquisition, financial assets valued at fair value, with unrealized gains and losses generally included in OCI, •Unlessobjective of firm’s business model is to hold an asset to collect interest and principal. –Then, valuation is at amortized cost (i.e., value-in-use), subject to impairment test –Business model concept makes it more difficult for management to opportunistically change intended use of the asset •After acquisition, most liabilities valued at amortized cost Copyright © 2015 Pearson Canada Inc.7 - 9 The Fair Value Option for Financial Instruments •Under IFRS 9, firm may designate financial assets/liabilities at acquisition as valued at fair value to reduce a mismatch. –Applies to assets/liabilities otherwise valued at amortized cost –Mismatch: Accounting volatility greater than real volatility •E.g., loans receivable valued at fair value •Bonds payable hedge the loans, valued at amortized cost •Unrealized gains/losses on loans included in net income •No offsetting loss/gain recorded on bonds •If bonds fair valued, losses/gains on bonds offset gains/losses on loans >> Continued Copyright © 2015 Pearson Canada Inc.7 - 10 The Fair Value Option for Financial Instruments (continued) •Accounting for changes in own credit risk –Firm has opted under IFRS 9 to fair value debt outstanding –Firm’s debt receives a credit downgrade –Market value of debt falls –Firm writes debt down to fair value, records a gain –Has firm really gained? •Barth, Hodden, and Stubben (2008) –IFRS 9 requires own credit risk gains/losses to be included in OCI Copyright © 2015 Pearson Canada Inc. Loan Loss Provisioning •Applies to loans valued at amortized cost •During 2007-2008 securities market meltdowns, huge loan losses reported by financial institutions contributed to investor loss of confidence •2013 IASB exposure draft –Include estimate of future losses in expected loan collections –Loan losses thus recognized sooner than when actually impaired, reducing investor shock –Relevance v. reliability tradeoff? Decision useful?

–Currently awaiting agreement with FASB on a converged standard 7 - 11 Copyright © 2015 Pearson Canada Inc. Fair Value v. Historical Cost •The 2007-2008 market meltdowns generated serious complaints about fair value accounting •Several analytical models study conditions under which each system is preferred –Allen & Carletti (2008) –Plantin, Sapra, & Shin (2008) –Models have restricted assumptions –Mixed empirical support 7 - 12 Copyright © 2015 Pearson Canada Inc. Derecognition and Consolidation •Purpose of new standards is to reduce abuses leading up to 2007/2008 market meltdowns –Derecognition •When can a firm remove assets from its books? –A serious question leading up to 2007-2008 market meltdowns –E.g., many firms transferred securitized mortgage assets to SIVs •IFRS 9.

•Can derecognize when substantially all risks and rewards of ownership are transferred.

•But no derecognition if control retained –Consolidation •IFRS 10 –Required when one entity controls another –Control exists when one firm has power over another and bears risk of return on its investment 7 - 13 Copyright © 2015 Pearson Canada Inc.7 - 14 Derivative Financial Instruments •Derivatives are financial instruments •Definition –A contract, the value of which depends on some underlying… –May not require an initial cash outlay –Generally settled in cash, not in kind •Derivatives valued at fair value under IFRS 9 •Unrealized gains and losses included in net income, except certain hedging contracts >> Continued Copyright © 2015 Pearson Canada Inc.7 - 15 Derivative Financial Instruments (Continued) •Hedge Accounting –Purpose of hedges is to manage risk •Price risks (e.g., commodity prices, interest and foreign exchange rates), credit risks (credit default swaps) –Fair value hedges •Gains and losses on the hedging instrument included in net income –Fair valuing the hedged item offsets effect on net income –Cash flow hedges •Gains and losses on the hedging instrument included in OCI, until the future transaction affects net income »Continued Copyright © 2015 Pearson Canada Inc.7 - 16 Derivative Financial Instruments (continued) •Benefits of Hedge Accounting –Reduces earnings volatility •Offset gains/losses by fair valuing hedged item (fair value hedge) •Delay gain/loss recognition by including in OCI until realized (cash flow hedge) »Continued Copyright © 2015 Pearson Canada Inc.7 - 17 Derivative Financial Instruments (Continued) •To Obtain Benefits of Hedge Accounting –Hedges must qualify •Must be highly effective –High negative correlation with hedged item –Hedges must be designated •To reduce temptation to speculate •Requires elaborate procedure and documentation Copyright © 2015 Pearson Canada Inc.7 - 18 Accounting for Intangibles •Many intangibles are not on balance sheet •Purchased intangibles, on balance sheet –Goodwill arising from an acquisition •Accounted for at cost •No amortization •Subject to impairmentg test –Can lead to major writedowns –Management devices to work around goodwill and related writedowns •“Pro-forma income,” e.g., TD Bank, 2000 Annual Report, JDS Uniphase Corp. See Theory in Practice 7.5 »Continued Copyright © 2015 Pearson Canada Inc.7 - 19 Accounting for Intangibles (continued) •Self-developed intangibles –Self-developed goodwill, e.g., from R&D •Hard to reliably determine fair value •Research costs written off as incurred, development costs capitalized, under IAS 38 •Development costs also written off under FASB standards •Recognition lag: instead of valuation on balance sheet, goodwill value from R&D shows up over time on income statement •Recognition lag responsible for low ability of net income to explain stock returns? –Lev & Zarowin (1999) argue yes >> Continued Copyright © 2015 Pearson Canada Inc.7 - 20 Accounting for Intangibles (continued) •Lev & Zarowin (1999), “The Boundaries of Financial Reporting…” –Their study documents a decreasing usefulness of earnings information –Usefulness evaluated by ability of earnings to explain abnormal share return •Low R 2 –And falling? •Low ERCs •Especially for research-intensive firms »Continued Copyright © 2015 Pearson Canada Inc.7 - 21 Accounting for Intangibles (continued) •Lev & Zarowin (continued) –Conclusion •Accounting for intangibles is inadequate •Their suggestion to improve usefulness –Capitalize successful intangibles after a “trigger point” is attained •Amortize over useful life •Like successful efforts accounting in oil and gas •Amounts capitalized and amortized may reveal inside information to investors, since it is management that has best knowledge of R&D value >> Continued Copyright © 2015 Pearson Canada Inc. Accounting for Intangibles (continued) •Capitalization of intangibles creates a problem of low reliability –Kanodia, Singh, & Spiro (2005) present a model suggesting that some degree of unreliability is “good” 7 - 22 Copyright © 2015 Pearson Canada Inc.7 - 23 Reporting on Risk •Risk controlled by natural hedging + hedging with derivatives •Some reasons for managing firm-specific risk, even though investors can diversify it away –Reduce investor estimation risk –Cash availability for planned capital expenditures –Control speculation by managers –Reduce likelihood of major losses, which often lead to lawsuits >> Continued Copyright © 2015 Pearson Canada Inc.7 - 24 Reporting on Risk (continued) •Reporting on Risk –Some reasons why reporting on other (firm-specific) risks also relevant to investors •Risk information may reduce estimation risk •Hedging may prevent losses, reducing auditor & firm legal liability •Risk reporting may control manager speculation >> Continued Copyright © 2015 Pearson Canada Inc.7 - 25 Reporting on Risk (continued) •A Measurement Perspective on Risk Reporting •Narrative, in MD&A –Canadian Tire Corp. 2012 Annual report •Text, Section 3.6 •Sensitivities Analysis –Husky Energy Inc., 2012 Annual Report •Table 7.2 •Value at Risk –Microsoft Corp., 2012 Annual Report Copyright © 2015 Pearson Canada Inc.7 - 26 Conclusions on Application of the Measurement Approach •Standard setters continue to favour current value measurements in financial statements –Conceptual framework emphasizes balance sheet approach –Some current value measurements are one-sided •Lower-of-cost-or-market, ceiling tests –Some backing off from fair value post 2007- 2008 market meltdowns •E.g., IFRS 9 business model concept allows increased use of amortized cost •Accountants are recognizing an increased obligation to measure and report on firm risk