Question

textbook: Financial Accounting Theory 8E - William Scott *I need at least 5 sentence explanations for each question.thanks* X Ltd. is a growth firm that uses very conservative accounting policies. Y Ltd. Is growing more slowly and uses fair value accounting for its capital assets and related amortization. Otherwise, X Ltd. and Y Ltd. are quite similar. They are the same size and have similar capital structures and betas. Required: 2 a) Both X and Y report the same GN in earnings this year. Which firm would you expect to have the greater security market response (earnings response co-efficient) to this good earnings news? Explain. 4 b) Suppose that X Ltd. had a much higher debt-to-equity ratio and beta than Y did. Would your answer to part a) change? Explain the effect each of these two factors has on the security market response. 4 c) Use the concept of signalling to explain why X and Y Ltd. might choose different accounting policies.

Answer 1

Dear, if two firms are similiar in size and resources, it depends on its accounting method for market response to which investors will be paying more attention. If a firm is using fair value accounting, it reflects a better picture in the mind of stakeholders than a other firm. So,

1) X ltd.' s market response would be higher

2) higher debt-equity doesn't mean the firm is much risky, it depends on market sentiments and other factors, if all other factors are favourable , the firm with more debt-equity ratio will attract stakeholders because it will give higher returns

On the other hand, if a firm is having high drbt-equity ratio, and market sentiments are not so good or predictable then the firm with less debt-equity will get higher response.

Assuming other factors are favourable, my answer to part 1 will not change vice versa

3) if we talk about accounting policies and method adopted by a enterprise depends on the type of business and management concerns. If the management thinks the investor to attract for long-term plans, it wouldn't follow fair-value on the other side if the firm wants to have a clear cut perception about the enterprise, it would follow fair value approach.