Advanced Theory Final Update Exam
Questions| Already answered| GRADED
A+
What is the measurement approach? - ANSWER-To decision usefulness--an approach to financial
reporting under which accountants undertake a responsibility to incorporate current values into the
financial statements proper, providing that this can be done with reasonable reliability, thereby
recognizing an increased obligation to assist investors to predict firm performance and value
Why are accountants moving toward the measurement approach? - ANSWER-Securities market may not
be as efficient as previously believed. If investors don't behave as rational decision theory, measurement
approach would help. Better measurements increase accountant's role in explaining share price
changes. Ohlson's clean surplus theory. Better measurement decreases auditor's liability when firms
financially suffer.
What does behavioral finance find that casts doubt on market efficiency? - ANSWER-1. Limited
attention: Individuals may not have the time, inclination, or ability to process all available information.
Will concentrate on information that is readily available such as the "bottom line" and ignore
information in notes and elsewhere in the annual report
2. Overconfidence: They overestimate the precision of information they collect themselves. Ex: An
investor who privately researches a firm may overreact to the evidence he/she obtains
3. Representativeness: Individual assigns too much weight to evidence that is consistent with the
individual's impressions of the population from which the evidence is drawn.
4. Self-attribution bias: Individuals feel that good decision outcomes are due to their abilities; whereas
bad outcomes are due to unfortunate realizations of states of nature (not their fault)
5. Motivated Reasoning: Individuals accept at face value information that is consistent with their
preferences (GN). If info is inconsistent with their preferences, received with skepticism, and individual
attempts to discredit it
What is prospect theory? - ANSWER-Behavioral based alternative to rational decision theory. An
investor considering a risky investment (prospect) will separately evaluate prospective gains and losses.
SEE PAGE 194
Prospect theory assumes loss aversion- individuals dislike even very small losses. Beginning at the point
where the investment starts to lose value, the investor's rate of utility loss is greater than the rate of
,utility increase for a gain in value. Investor holds on to losing stocks and sells winners. Investor behaves
based on payoff probabilities.
Is Beta Dead? - ANSWER-Beta isn't dead, it's just unstable.
Yes: Beta predicts better using 50 years of data than 28 years (study)
No: Not beta, investor confidence affects share returns
c. Other risk variables explain stock returns (book-to-market, firm size, momentum)—suggests increased
role of reporting on risk
Is there excess market volatility? - ANSWER-Study: Assume market inefficiency- stock prices depend on
dividends, but aggregate stock price volatility is greater than aggregrate dividend volatility
a. Shiller found that the variability of the stock market index was several times greater than the
variability of aggregate dividends. Evidence of market inefficiency. Behavioural factors increase stock
market volatility. Model of Daniel, Hirshleifer, and Subrahmanyam implies excess market volatility as
share prices overshoot and then fall back. Share price begins to rise. Rational investors anticipate the
actions of less sophisticated investors and instead "jump on the bandwagon" to take advantage of price
run up while it lasts. Result: excess volatility in market since share price exceeds its efficient market
value.
What anomalies exist? - ANSWER-Post Announcement Drift (PAD): Efficient securities market theory
predicts immediate response to GN or BN. Thus, investors underestimate the effect of current earnings
on future earnings
Accruals anomaly: Markets respond when operating cash flow is high, not when accruals are high. Thus,
investors are slow in understanding the different properties of accruals and operating cash flows
Reason for accruals anomaly:
• Behavioral biases: They are slow in realizing that accruals eventually reverse, Initially ignore the fact
that high accrual firms have low future earnings
• Rational investors are subject to: Transactions costs n Risk
Reason exist from 1st time:
, • Non-rational investors, behavioral biases
• Rational investors take time to learn whether expected earning power has changed; they update their
prior probabilities about future earnings as new information arrives
What are the implications of these inefficiencies for financial reporting? - ANSWER-Inefficiencies add an
important role for financial reporting, to reduce inefficiencies by making the mispricing between the
inefficient market price of the firm and the efficient market price of the firm--high quality reporting does
this. Can help behaviorally biased investors improve their decisions. Can speed up corrections or
mispricing caused by noise trading. Can help rational investors learn over time or, by releasing publicly
available information, reduce the effects of higher order beliefs.
What is the low R square (Value Relevance of Financial Statement Information) prob of ERC studies? -
ANSWER-Empirical evidence that net income explains very little share price variation. A better
measurement may increase accounting "market share" in explaining share price changes.
What are stock market bubbles? - ANSWER-Wherein share prices rise far above fundamental values--an
extreme case of market volatility. Bubble behavior can continue for some time and it's difficult to
predict when it will end. Eventually, it will burst because of growing beliefs of impending recession or
increasing inflation.
How does securities market efficiency compare to behavioral finance? - ANSWER-Behavioral finance
theory is inconsistent with market efficiency and rational decision making theories. Average beta risk of
high momentum stocks are less than market. Contrary to random walk assumption- over-confidence-
positive serial correlation of stock prices.
What are the limits to arbitrage? - ANSWER-Another reason for the persistence of anomalies. Costs
incurred by investors that limit their ability to fully exploit an anomaly and thereby arbitrage it away.
Two limits: Transaction costs and risk
Is there a cogent defense of investor rationality? If so, what is it? What is an alternative view? -
ANSWER-Dropping rational expectations assumption. Brav and Heaton: In face of estimation risk,
rational investors learn over time, revising their beliefs as new information comes along. Instead of
immediately figuring out full information content of financial statements, as in rational expectations
assumption. Suggests that rational investor behavior can create share price behavior similar to that of
the anomalies.
Questions| Already answered| GRADED
A+
What is the measurement approach? - ANSWER-To decision usefulness--an approach to financial
reporting under which accountants undertake a responsibility to incorporate current values into the
financial statements proper, providing that this can be done with reasonable reliability, thereby
recognizing an increased obligation to assist investors to predict firm performance and value
Why are accountants moving toward the measurement approach? - ANSWER-Securities market may not
be as efficient as previously believed. If investors don't behave as rational decision theory, measurement
approach would help. Better measurements increase accountant's role in explaining share price
changes. Ohlson's clean surplus theory. Better measurement decreases auditor's liability when firms
financially suffer.
What does behavioral finance find that casts doubt on market efficiency? - ANSWER-1. Limited
attention: Individuals may not have the time, inclination, or ability to process all available information.
Will concentrate on information that is readily available such as the "bottom line" and ignore
information in notes and elsewhere in the annual report
2. Overconfidence: They overestimate the precision of information they collect themselves. Ex: An
investor who privately researches a firm may overreact to the evidence he/she obtains
3. Representativeness: Individual assigns too much weight to evidence that is consistent with the
individual's impressions of the population from which the evidence is drawn.
4. Self-attribution bias: Individuals feel that good decision outcomes are due to their abilities; whereas
bad outcomes are due to unfortunate realizations of states of nature (not their fault)
5. Motivated Reasoning: Individuals accept at face value information that is consistent with their
preferences (GN). If info is inconsistent with their preferences, received with skepticism, and individual
attempts to discredit it
What is prospect theory? - ANSWER-Behavioral based alternative to rational decision theory. An
investor considering a risky investment (prospect) will separately evaluate prospective gains and losses.
SEE PAGE 194
Prospect theory assumes loss aversion- individuals dislike even very small losses. Beginning at the point
where the investment starts to lose value, the investor's rate of utility loss is greater than the rate of
,utility increase for a gain in value. Investor holds on to losing stocks and sells winners. Investor behaves
based on payoff probabilities.
Is Beta Dead? - ANSWER-Beta isn't dead, it's just unstable.
Yes: Beta predicts better using 50 years of data than 28 years (study)
No: Not beta, investor confidence affects share returns
c. Other risk variables explain stock returns (book-to-market, firm size, momentum)—suggests increased
role of reporting on risk
Is there excess market volatility? - ANSWER-Study: Assume market inefficiency- stock prices depend on
dividends, but aggregate stock price volatility is greater than aggregrate dividend volatility
a. Shiller found that the variability of the stock market index was several times greater than the
variability of aggregate dividends. Evidence of market inefficiency. Behavioural factors increase stock
market volatility. Model of Daniel, Hirshleifer, and Subrahmanyam implies excess market volatility as
share prices overshoot and then fall back. Share price begins to rise. Rational investors anticipate the
actions of less sophisticated investors and instead "jump on the bandwagon" to take advantage of price
run up while it lasts. Result: excess volatility in market since share price exceeds its efficient market
value.
What anomalies exist? - ANSWER-Post Announcement Drift (PAD): Efficient securities market theory
predicts immediate response to GN or BN. Thus, investors underestimate the effect of current earnings
on future earnings
Accruals anomaly: Markets respond when operating cash flow is high, not when accruals are high. Thus,
investors are slow in understanding the different properties of accruals and operating cash flows
Reason for accruals anomaly:
• Behavioral biases: They are slow in realizing that accruals eventually reverse, Initially ignore the fact
that high accrual firms have low future earnings
• Rational investors are subject to: Transactions costs n Risk
Reason exist from 1st time:
, • Non-rational investors, behavioral biases
• Rational investors take time to learn whether expected earning power has changed; they update their
prior probabilities about future earnings as new information arrives
What are the implications of these inefficiencies for financial reporting? - ANSWER-Inefficiencies add an
important role for financial reporting, to reduce inefficiencies by making the mispricing between the
inefficient market price of the firm and the efficient market price of the firm--high quality reporting does
this. Can help behaviorally biased investors improve their decisions. Can speed up corrections or
mispricing caused by noise trading. Can help rational investors learn over time or, by releasing publicly
available information, reduce the effects of higher order beliefs.
What is the low R square (Value Relevance of Financial Statement Information) prob of ERC studies? -
ANSWER-Empirical evidence that net income explains very little share price variation. A better
measurement may increase accounting "market share" in explaining share price changes.
What are stock market bubbles? - ANSWER-Wherein share prices rise far above fundamental values--an
extreme case of market volatility. Bubble behavior can continue for some time and it's difficult to
predict when it will end. Eventually, it will burst because of growing beliefs of impending recession or
increasing inflation.
How does securities market efficiency compare to behavioral finance? - ANSWER-Behavioral finance
theory is inconsistent with market efficiency and rational decision making theories. Average beta risk of
high momentum stocks are less than market. Contrary to random walk assumption- over-confidence-
positive serial correlation of stock prices.
What are the limits to arbitrage? - ANSWER-Another reason for the persistence of anomalies. Costs
incurred by investors that limit their ability to fully exploit an anomaly and thereby arbitrage it away.
Two limits: Transaction costs and risk
Is there a cogent defense of investor rationality? If so, what is it? What is an alternative view? -
ANSWER-Dropping rational expectations assumption. Brav and Heaton: In face of estimation risk,
rational investors learn over time, revising their beliefs as new information comes along. Instead of
immediately figuring out full information content of financial statements, as in rational expectations
assumption. Suggests that rational investor behavior can create share price behavior similar to that of
the anomalies.
