Question

textbook: Financial Accounting Theory 8E - William Scott

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

Answer
Differences	X Ltd.	Y Ltd.
Accounting Policy	Conservative	Fair Value for Capitlisation
Growth	Modern	More Slowly
Debt to Equity	Higher	Lower
Size, capital Structure and betas are similar in both companies.
a)
If the same GN in earning, the reported net income is what investors expected it to be, there would be not much information content in that reported net income.
In this situation greater security market response will there in Y Ltd because this company having better accounting policy as imarket required "Fair Value" and
Y Ltd. is still following conservative policy of accounting and not standing with market requirement.
b) If X Ltd have higher debt to Equity Ratio and beta than Y Ltd. That means still X Ltd will have less security market respsonse. So answer will be same as (a).
c) Concept of signalling tell us how to use insider information or data to make the decision for investment market.
As both company having different accounting policy should continue other wise maket volatility shall be arised in initial stage if there is not regulatory mandatorisation.