Question

In: Finance

Stocks that are more risky earn higher average returns. However, managers often manipulate accounting numbers to...

Stocks that are more risky earn higher average returns. However, managers often manipulate accounting numbers to smooth the volatility of their company’s earnings and try to make the company appear less risky. How can you explain this behavior?

Solutions

Expert Solution

It's true that Stocks that are more risky earn higher average returns. However the stocks that are more risky give rise to:

  • Volatile earnings
  • Which in turn leads to volatility in share prices
  • Which in turn leads to volatility in the returns

Investors and traders are therefore, in general averse to volatility in earnings as it leads to volatility in share prices that lead to trading losses for them.

They therefore prefer stability in earnings. Management knows this preference of investors and hence they engage into smoothening of the company's earnings and try to make company appear less risky.

This is definitely an unethical practice, but then there is an agency problem. Managerial compensation are linked to the stability and sustainability of the share prices. Their compensation is liked to the trends in the stock prices and their behavior. It therefore lures managers to smoothen the earnings and make the stock appear less volatile. This is the reason behind their behavior.


Related Solutions

People who earn a higher salary can afford more goods, including healthcare. However, according to Grossman,...
People who earn a higher salary can afford more goods, including healthcare. However, according to Grossman, they will choose a higher desired health stock. Why?
Which of the following is correct about accrual-basis accounting and cash-basis accounting? a. Managers can manipulate...
Which of the following is correct about accrual-basis accounting and cash-basis accounting? a. Managers can manipulate accruals downward to inflate the firm's net income. b. If the net income is calculated at the end of a company's economic life, i.e. after the business is wrapped up and liquidated, then the net income calculated using cash-basis accounting is greater than that using accrual-basis accounting. c. Under accrual-basis accounting, expense is recognized in the same period as the revenue it relates to...
Research has shown in the past that high B/M stocks generally have higher average returns than...
Research has shown in the past that high B/M stocks generally have higher average returns than low B/M stocks over long periods of time. Explain how efficient market hypothesis and behavioral finance would differ in their explanations of this phenomenon.
Accrual accounting matches revenue with expenses, however accruals can be used to manipulate income and expenses....
Accrual accounting matches revenue with expenses, however accruals can be used to manipulate income and expenses. In the Forbes Magazine article, “Cash Doesn’t Lie,” written by Daniel Fisher, the author discusses the use of negative accruals, changes to estimates and recognizing income before it is earned. Read the article and then: a. Discuss the use of each of these three techniques and their effect on current and future earnings reporting. b. How should changes of accounting estimates that significantly affect...
Some portfolio managers claim that they charge higher MER because they can generate higher returns for...
Some portfolio managers claim that they charge higher MER because they can generate higher returns for investors. Do you agree with this statement? What other things might generate higher returns for investors?
The concept of an equity premium means that holders of stocks will tend to earn more...
The concept of an equity premium means that holders of stocks will tend to earn more over time than holders of bonds because stocks are more risky. a.True b.False If a company borrows money and uses these funds to buy back its own stock it is increasing its financial leverage. a.True b.False Market evidence shows that, on average, the price of a company's stock will increase when it announces a new round of equity financing." a.True b.false Since depreciation does...
The concept that core competencies must be sustainable for firms to earn above average returns is...
The concept that core competencies must be sustainable for firms to earn above average returns is well established. However, core competencies can be threatened or even become obsolete. Explain how firms can strengthen and protect their core competencies. 400 words
9. Mr. Richards has a new client will earn much higher returns than normal because of...
9. Mr. Richards has a new client will earn much higher returns than normal because of their risk profile. The client will role $75,000 into an account with the firm and then they will make additional monthly deposits of $2,000 per month for the next 25 years. He also wants to illustrate the returns for a bank CD at 2%, market returns at 4% and normal returns for him of 8%. To further illustrate the power of his returns, he...
You analyzed the returns of a sample of stocks. You found that, on average, the firms...
You analyzed the returns of a sample of stocks. You found that, on average, the firms with high E/P ratios have higher subsequent returns. (i) Discuss an explanation for this pattern that is consistent with the EMH. (ii) Discuss an explanation that is not consistent with the EMH. (A couple sentences per part.)
Financial media often invites fund managers or analysts to predict future stock returns and will only...
Financial media often invites fund managers or analysts to predict future stock returns and will only invite them back if their predictions produce positive outcomes. This type of behavior by the media could lead to which of the following bias? 1-Availability heuristic/bias 2-Gambler’s fallacy 3-Hot hand fallacy You purchased 200 shares of GPRO when it went IPO. The stock doubled in price within 3 months. You sold 100 shares, thus recovered your cost, and decided to keep the other 100...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT