Reference no: EM13796989

What are discretionary accruals? Why are they useful in testing the three PAT hypotheses?

The methodology designed by Jones (1991)-called the Jones Model-is usually used to estimate discretionary accruals. Outline in words how the Jones Model measures discretionary accruals.

For good corporate governance, contracts should be designed efficiently. A researcher finds, for a sample of firms, that the covenant slack in debt contracts (the difference between the critical value of a debt covenant ratio as specified in a debt contract and the value of that ratio on the borrower's books on the date of the contract) is greater on average with greater variability over time of the debt covenant ratios. Is this finding evidence of efficient or opportunistic contracting? Explain your answer.

Discretionary accruals can be used opportunistically or efficiently. Conservative accounting can be regarded as a form of discretionary accruals because the firm chooses to report-that is, accrue-lower asset values and/or higher liability values. A researcher finds that firms with income escalator clauses in their debt contracts (an escalator clause increases the covenant level of net worth the firm is required to maintain under the contract by a percentage of reported net income) tend to use more conservative accounting than similar firms with no escalator clauses in their debt contracts. Is this finding consistent with efficient or opportunistic contracting? Explain your answer.