Question 1 (26 points)

a. The two roles of accounting are the stewardship role and the information role. To what types of

information asymmetry are these roles related and what are the economic benefits that

accounting information yields? (6 points)

b. Use game-theoretic reasoning about the interaction between an auditor and corporate

management to explain why it is unlikely that accounting scandals will ever be fully prevented.

(5 points)

c. What is the reason that accounting choices might have economic consequences? (4 points)

d. What are the three channels through which economic consequences happen according to

Positive Accounting Theory? (The three ‘hypotheses’.) (3 points)

e. (i) Explain what discretionary accruals are. (2 points)

(ii) Why would researchers be interested in knowing these, and (2 points)

(iii) How can you empirically estimate the discretionary accruals? (4 points)

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Answer

a. Stewardship: Moral hazard; EB: reduction in agency costs (1+2 points)

Information: Adverse selection; EB: lower cost of capital (due to lower estimation risk) (1+2

points)

b. If penalties and detection efforts are extremely large, fraud will not occur. However, when fraud

does not occur it is not efficient to spend that much effort in detecting fraudulent errors. When this is

however lowered, fraud may become attractive in some cases with high payoffs.

c. Because firms are connected to third parties through formal or implicit contracts which are often

based on accounting numbers. Therefore third parties and managers adjust their decisions which leads

to economic consequences(changes in cash flows).

d. see book/lecture slides (1 point each hypotheses)

e. (i) Discretionary accruals are the part of total accruals that managers can discretionarily decide

upon; (ii) these can be used to investigate how managers use discretion to affect earnings, so to study

earnings management. (iii) It can be estimated by the Jones model. Explanation Jones model see

book+slides); it is important to indicate what part of the regression are the resulting discretionary

accruals.