Re-cap from last week

1. 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

2. 306-684 Financial Accounting Seminar 4 – the Information Perspective on Decision Usefulness Semester 2, 2009

3. 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

4. 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

5. Learning objectives cont. • Key terms/concepts for the week: • market model • abnormal returns • event study (and associated difficulties) Semester 2, 2009

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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