Re cap from last week
This presentation is the property of its rightful owner.
Sponsored Links
1 / 30

Re-cap from last week PowerPoint PPT Presentation


  • 53 Views
  • Uploaded on
  • Presentation posted in: General

Re-cap from last week. Single person decision theory accounting information used to update expected payoffs; applies to share markets market efficiency with respect to public information; new information is rapidly priced; implications for disclosure;

Download Presentation

Re-cap from last week

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript


Re cap from last week

Re-cap from last week

  • Single person decision theory

    • accounting information used to update expected payoffs;

    • applies to share markets

      • market efficiency

        • with respect to public information;

        • new information is rapidly priced;

        • implications for disclosure;

        • summing up the role for accounting information.

        • will dictate the informativeness of price

Semester 2, 2009


306 684 financial accounting

306-684 Financial Accounting

Seminar 4 – the Information Perspective on Decision Usefulness

Semester 2, 2009


Learning objectives

Learning Objectives

  • To appreciate the information perspective on decision usefulness

    • An application of decision theory and efficient markets theory to understand investor decision making using financial accounting information

  • To introduce empirical capital markets research in accounting

    • Ball & Brown [1968] and others

Semester 2, 2009


Learning objectives cont

Learning Objectives (cont.)

  • To understand the importance of the following metrics/concepts for understanding the role of accounting information in the capital market

    • earnings response coefficients;

    • persistent/transitory components of earnings;

    • earnings quality.

  • To appreciate the limitations of the research for policy recommendations.

  • Semester 2, 2009


    Learning objectives cont1

    Learning objectives cont.

    • Key terms/concepts for the week:

      • market model

      • abnormal returns

      • event study (and associated difficulties)

    Semester 2, 2009


    The information perspective

    The Information Perspective

    • Until the last few years, the information perspective on decision usefulness has dominated financial accounting theory and practice

    • The information perspective of decision usefulness:

      • Classifies people as Bayesian when making their investment decisions. Assumes that what users require is information about firms that leads to revisions of prior expectations in an efficient capital market.

    Semester 2, 2009


    Central questions

    Central questions

    • How do we establish what accounting information has an impact on capital markets - enabling users to revise prior expectations?

    • What can accounting regulators learn from this impact about what accounting information should be reported in financial reports?

    Semester 2, 2009


    The information perspective1

    The Information Perspective

    • Characteristics:

      • Based on single person decision theory

        • It is the investor’s responsibility to predict future firm performance and make investment decisions;

      • It is the accountant’s role to supply useful financial statement information, to assist investors

    Semester 2, 2009


    The information perspective2

    The Information Perspective

    • Characteristics (cont.)

      • Depends on efficient securities market theory

      • The market can interpret information from any source

      • OK to use HC accounting in financial statements proper (lower relevance, higher reliability), supplemented by lots of information in notes (e.g. RRA, MD&A, more relevant, less reliable)

    Semester 2, 2009


    Market response to accounting information

    Market Response to Accounting Information

    • Could ask users whether information is useful...….

    • Recall the theoretical links (predictions of investor behaviour):

      • Investors have prior beliefs about future performance

      • Release of accounting income number is a potential information source, causing belief revision

      • Resulting investment decisions – increased trading volume, share price movement

    Semester 2, 2009


    Market response to accounting information1

    Market Response to Accounting Information

    • Hard to prove,

      • Lots of empirical evidence that market responds to accounting information

  • We concentrate mainly on the information content of net income

  • Semester 2, 2009


    Market response studies

    Market response studies

    • How do we set up a study that tests decision usefulness???

      • Decide on observation window

      • Identify expected return

      • Determine market response

    Semester 2, 2009


    Identify observation window

    Identify observation window

    • Causation v. Association

      • Narrow window studies

        • Evidence that financial statement information causes security price change

      • Wide window studies

        • Evidence that financial statement information is associated with security price change

    Semester 2, 2009


    Market response to accounting information2

    Market Response to Accounting Information

    • Expected returns

      • All expected income is already reflected in share price; so

    • Empirically model relationship between unexpected (abnormal) earnings and abnormal share returns

      • To calculate abnormal returns, we need to know expected returns (use the market model)

      • To calculate abnormal earnings, we need to know expected earnings

    Semester 2, 2009


    Estimation of investors earnings expectations

    Estimation of Investors’ Earnings Expectations

    • Under ideal conditions:

      • expected income = accretion of discount

    • Non-ideal conditions

      • Time series approach

        • Zero persistence: all earnings unexpected (no info in last year’s E about future E)

        • Complete persistence: proxy unexpected earnings by change in earnings

      • Analysts’ forecasts

        • Now commonly used

    Semester 2, 2009


    Event studies

    Event studies

    • Testing the decision usefulness of the information released

      • for each firm, collect its actual return for the period prior to the earnings announcement;

      • collect the market return for the same period;

      • run the regression Rjt =  + jRmt + jt

      • This gives an estimate of  and  and the regression model

      • Obtain Rjt=0 and use the model to computejt=0

    Semester 2, 2009


    Ball brown 1968

    Ball & Brown [1968]

    • Ball and Brown 1968

    • The first study to document statistically a share price response to reported net income

    • Foundation of empirical financial accounting research

    • Methodology still used today

      • improved a little...

    Semester 2, 2009


    Ball brown methodology

    Ball & Brown Methodology

    • For each sample firm:

      • Estimate investors’ earnings expectations (proxied by last year’s actual)

      • Classify each firm as GN (actual earnings > expected) or BN (vice versa)

      • Estimate abnormal share return for month of release of earnings (month 0), using market model

    Semester 2, 2009


    Ball brown methodology cont

    Ball & Brown Methodology (cont.)

    • Calculate average abnormal share return for GN firms for Month 0

    • Calculate average abnormal share return for BN firms for Month 0

    • Repeat for Months -1, -2,…, -11, and Months +1, +2,…,+6.

    • Plot results

      • See Figure 5.3

    Semester 2, 2009


    Ball brown conclusion

    Ball & Brown Conclusion

    • Observations

      • stock market reacts to accounting information;

      • begins to anticipate the GN or BN in earnings 12 months prior to month of earnings announcement

    • Why?

      • Prices lead earnings

      • Consistent with securities market efficiency and underlying rational decision theory

      • Contrary to critics, HC-based statements are decision-useful!

      • Note post-earnings announcement drift

    Semester 2, 2009


    Building on ball and brown

    Building on Ball and Brown

    • Huge impact of this research based on the following:

      • consistent with decision theory

      • accounting earnings appear useful

      • non-cash accounting policies were claimed as irrelevant

    • Can we establish how and when accounting information is more or less useful?

    Semester 2, 2009


    Building on ball and brown1

    Building on Ball and Brown….

    • Many other questions followed

      • Does the amount of abnormal share price change correlate with the amount of GN/BN?

        • Remember that BB’s study was based only on the sign of UE

      • Yes

      • Many other questions evaluated

        • Market response to information contained in new accounting standards, auditor changes etc

    • Response to Balance sheet information? Hard to find

    Semester 2, 2009


    Building on ball and brown2

    Building on Ball and Brown….

    • Different question

      • Do characteristics of unexpected earnings affect magnitude of abnormal share return?

    • Earnings response coefficient [ERC] measures the extent of share price return in response to unexpected earnings

      • ERC is measuring the average ‘info impact’

    Semester 2, 2009


    Factors affecting erc

    Factors Affecting ERC

    • What do we know about ERC?

      • Risk (β): Higher β – Lower ERC

      • Capital Structure: Higher D/E – Lower ERC

      • Earnings persistence: Higher persistence – Higher ERC

      • Earnings quality: Higher quality – Higher ERC

      • Growth opportunities: Higher growth opportunities – Higher ERC

      • Investor expectations: more precise analysts’ forecasts – more similar investor expectations – higher ERC

      • Firm size?

    Semester 2, 2009


    Types of earnings events

    Types of earnings events

    • Permanent: ERC can be > than 1, expected to persist indefinitely

    • Transitory: ERC=1, affecting earnings in current year only

    • Price irrelevant: ERC=0

    Semester 2, 2009


    Earnings quality higher quality higher erc

    Earnings quality-higher quality, higher ERC

    • High quality earnings represented by the high values of the main diagonal probabilities of our info system

      • But how is earnings quality measured?

        • Use net income=CFO + accruals

          • CFO, not subject to estimation error

          • Accruals: discretionary judgement

            • If no estimation error, high quality earnings

            • If there is estimation error, then either earnings management or a mistake

    Semester 2, 2009


    More on earnings quality

    More on Earnings Quality

    • How to measure?

      • Main diagonal probabilities of information system

      • Relationship of accruals and operating cash flows

      • Fundamentals, e.g., Δinventory/sales

        • A role for balance sheet information

    • Line-by-line evaluation

    Semester 2, 2009


    Implications of erc research

    Implications of ERC Research

    • Why are ERCs important?

      • They tell us what things affect the information content of accounting earnings

    • Further supports single-person decision theory and efficient markets theory

    • Importance of full disclosure

      • So investors can evaluate earnings quality and earnings persistence…..

    • So, improved Decision Usefulness of financial statements

    Semester 2, 2009


    Implications of capital markets research for accounting policy

    Implications of Capital Markets Research for Accounting Policy

    • Is the “best” accounting policy the one that results in the greatest share price reaction?

    • Not necessarily

      • Benefit to investors v. benefit to society

      • Accounting information a “public good”

        • Use by one person doesn’t prevent use by another

        • Firms cannot charge for it

      • More on this in Seminars 10 and 11 on Regulation!

    Semester 2, 2009


    Conclusions

    Conclusions

    • The role of accounting information is to expand and improve the stock of information available to the market, in order to improve investor decision making

      • Empirical research informs us if this role is being achieved

    Semester 2, 2009


  • Login