23 May IS THIS TYPE OF EARNINGS MANAGEMENT GOOD OR BAD IN TERMS OF USEFULNESS TO EQUITY INVESTORS?
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)
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)
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)
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)
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