Question $2(15$ marks$)$

Part $($a$)$

Ball and Brown$$s research examined the association between stock returns and earnings when the period $($or window$)$ over which earnings and stock returns are measured is one year. In later periods, researchers examined the association between stock returns and earnings when the period $($or window$)$ over which earnings and stock returns are measured is greater than one year.

Required

Discuss how the strength of the association between earnings and stock returns changes as the window increases from one year to greater than one year $(5$ marks$).$

Part $($b$)$

In an article published in The Accounting Review, Sloan $(1996)$ decomposed net income into accruals and operating cash flows and compared the relative magnitudes of their persistence. Sloan found that operating cash flows have a higher persistence than accruals. Sloan also found that the stock price of firms in his sample increased in response to good news and decreased in response to bad news in net income. But the magnitude of this stock price response did not vary with the relative proportions of accruals and operating cash flows that constituted net income.

Required

a$)$

Briefly explain one reason why operating cash flows have higher persistence than accruals $(1$ marks$).$

b$)$

Explain why Sloan$$s finding about stock price response not varying with relative proportions of accruals and operating cash flows is an example of an efficient market anomaly $(2$ marks$).$

Part $($c$)$

Knowing that you are attending an accounting theory course, your friends Norman and Hassan approach you for some advice on investing. They have very different ideas about investing and are hoping you can settle some arguments they are having about how rational investors behave.

Required

a$)$

Indicate the usual assumption about the risk preferences of rational investors. Explain to Norman and Hassan why this is the usual assumption $(2$ marks$).$

b$)$

Norman and Hassan are intrigued by your explanation of risk preferences and they want to learn more. Norman recounts that his father was an egg farmer, and for any problem in life his father$$s only answer was, $$Son$,$ don$$t put all your eggs in one basket.$$ Norman wants to know whether this down$-$to$-$earth wisdom might apply to investing. Explain how this idea applies to investing $(2$ marks$).$

c$)$

Hassan surprises you by asking the following: $$I was looking at your accounting theory notes the other day, and I saw references to states of nature and factors that affect share returns.$$ You explain to Hassan that the three factors are market$-$wide factors,

industry

$-$wide factors, and firm$-$specific factors. Indicate one example for each of the factors listed above $(3$ marks$).$