Stream I - Lecture 5

Question 1

What is the accruals anomaly?

Answer 1

This is where earnings surprises are affected by accruals estimates. Accruals = Earnings - Operating Cash Flows. Investors overvalue accrual components.

Question 2

What is the gender effect?

Answer 2

Men tend to be riskier than women

Question 3

How can you exploit the accruals anomaly as an investor?

Answer 3

Takes a long position in the portfolio with low accruals and go short on the portfolio with high accruals. Approximately a return of 10%.

Question 4

What assumption is necessary for agency theory?

Answer 4

Semi-strong form efficiency

Question 5

What is post earnings announcement drift (PEAD)?

Answer 5

Abnormal returns for several months after earnings announcements

Question 6

Why may analysts’ earnings forecast be partly responsible for the accruals anomaly?

Answer 6

Their unrealistic expectations may cause the market to overreact

Question 7

How do we calculate accruals?

Answer 7

Accruals = Earnings - Operating Cash Flows (OCF)

e.g. depreciation, amortisation, impairment, write-downn

Question 8

What are discretionary accruals?

Answer 8

These are the managed accruals

Question 9

What hypotheses can we use to argue the case for agency theory existing?

Answer 9

1) Bonus plan hypothesis - Bonus plans create incentives to make income-increasing accounting choices
2) Debt covenant hypothesis - Approaching violation of accounting0based debt covenants creates incentives to make income-increasing accounting choices
3) Political cost hypothesis - Higher political costs create incentives to make income decreasing accounting choices

Question 10

What is Positive Accounting Theory (PAT) and why is he word ‘Positive’ used?

Answer 10

This is a theory that was developed to explain managers’ accounting choices and capital market reactions to accounting information under efficient markets. it is called ‘positive’ because normative theories prescribe how accounting decision SHOULD be made.

Question 11

Why does agency theory exist?

Answer 11

Information asymmetry, moral hazard

Question 12

What is an agency relationship?

Answer 12

The principle (shareholders) engages the agents (managers) to perform some service on their behalf

Question 13

What are agency costs and what are their uses?

Answer 13

They are economic (NOT ACCOUNTING) costs that reduce moral hazard and information asymmetry problems. They include:

• Excessive dividends payments
• Taking on additional debt, with the new debt holders competing with original debt holders for repayment. This will lead to less investment in high-risk projects as it may not be beneficial to debt holders as they have a fixed claim

Question 14

What are the two most important types of debt covenants?

Answer 14

1) Minimum interest cover

2) Profit margin ratios

Question 15

What is the 2nd hypotheses of positive accounting theory (PAT)?

Answer 15

Ceteris paribus, managers will be motivated to choose accounting policies to avoid covenant default 9and bankruptcy costs) and maximise freedom to take decisions. They will choose accounting policies which:

• Increase asset values
• Minimise liabilities
• Increase profits
• Reduce interest costs

Question 16

What is the political visibility of a firm?

Answer 16

How much they are being watched by external stakeholders. This visibility is influenced by:

• The size of the firm
• Large profits/losses
• Controversial disclosures
• Nature of industry (e.g. oil and gas)

Question 17

What do government favours have to do with PAT?

Answer 17

A manager may manipulate earnings to earn these favours. For example, if they are close to earning a subsidy they may manipulate earnings numbers.

Question 18

What are some red flags of earnings manipulation?

Answer 18

• Unexplained transactions that boost profits
• Auditor changes
• Unusual increases in inventory