Assignment 2

Version 1

Marks available 50

Question 1 (25 marks)

Empirical tests of the three hypotheses of positive accounting theory (PAT) are often based on the amount of discretionary accruals contained in net income.

Required:

1. What are discretionary accruals? Why are they useful in testing the three PAT hypotheses? (5 marks)
2. The methodology designed by Jones (1991)—called the Jones Model—is usually used to estimate discretionary accruals. Outline in words how the Jones Model measures discretionary accruals. (6 marks)
3. For good corporate governance, contracts should be designed efficiently. A researcher finds, for a sample of firms, that the covenant slack in debt contracts (the difference between the critical value of a debt covenant ratio as specified in a debt contract and the value of that ratio on the borrower’s books on the date of the contract) is greater on average with greater variability over time of the debt covenant ratios. Is this finding evidence of efficient or opportunistic contracting? Explain your answer. (5 marks)
4. Discretionary accruals can be used opportunistically or efficiently. Conservative accounting can be regarded as a form of discretionary accruals because the firm chooses to report—that is, accrue—lower asset values and/or higher liability values. A researcher finds that firms with income escalator clauses in their debt contracts (an escalator clause increases the covenant level of net worth the firm is required to maintain under the contract by a percentage of reported net income) tend to use more conservative accounting than similar firms with no escalator clauses in their debt contracts. Is this finding consistent with efficient or opportunistic contracting? Explain your answer. (9 marks)

Question 2 (25 marks)

Income smoothing is a common earnings management pattern. Many managers feel that their reputations, and their firms’ share prices, are enhanced by a smooth, steadily growing sequence of reported earnings.

Required:

1. A behaviourally biased investor observes a firm’s earnings increasing steadily over time. The investor decides that this firm is a growth firm. Identify the specific behavioural bias that may underlie this investor behaviour and explain why it leads to identifying the firm as a growth firm. Is the investor necessarily correct in this identification as a growth firm? Explain why or why not. (6 marks)
2. Some firms have used low-persistence accruals to smooth net income to a level that the firm’s managers felt would persist. Is this type of earnings management good or bad in terms of usefulness to equity investors? Does such smoothing benefit the manager whose compensation depends on reported net income? Explain why or why not. (6 marks)
3. A researcher finds that firms that are growing rapidly have, on average, a lower proportion of manager compensation based on net income, relative to share-based compensation, than firms that are not growing rapidly. Explain why. Use concepts of recognition lag, sensitivity, and precision in your answer. (7 marks)
4.  A firm that has smoothed earnings for many years needs to manage its earnings upwards this year to maintain the pattern of smooth, steady earnings that it has been reporting. The firm anticipates a period of lower earnings next year. Would the firm manager be wise to smooth earnings this year? Explain why or why not. (6 marks)