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Chapter 8. Usefulness of Accounting Information to Investors and Creditors. Lecture. Earnings, Dividends, and Stock Prices Residual Income Models Risk and Return Efficient-Markets Hypothesis Capital Markets Research in Accounting Value of Accounting Information Evidence from Return Data

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Chapter 8 l.jpg

Chapter 8

Usefulness of Accounting Information to Investors and Creditors


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Lecture

  • Earnings, Dividends, and Stock Prices

  • Residual Income Models

  • Risk and Return

    • Efficient-Markets Hypothesis

    • Capital Markets Research in Accounting

  • Value of Accounting Information

    • Evidence from Return Data

    • Evidence from Direct Valuation

  • Accounting data and creditors

  • Earnings Forecasting

  • Empirical Research and Standard Setting


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Earnings, Dividends, and Stock Prices

  • Stock price is equal to the present value (capitalized value) of future expected earnings, adjusted by the dividend payout ratio.

  • Current income has value in predicting future dividends via its value to predict future earnings.


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From Earnings to Stock Prices

  • Miller and Modigliani (1961)

    • argue that dividend policy is irrelevant to firm valuation.

    • show that the value of the firm is equal to the present value of future expected net cash flows.

    • define net cash flows per period as operating cash flow minus cash investment in assets (the same definition as that used for capital budgeting analysis).

  • The attractiveness of the cash flow valuation model for accounting is that it maps directly onto the accounting system.


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Residual Income Models

  • Residual Income (RI) is a general term for income in excess of a charge for the capital that is employed to generate that income.

  • When applied to the enterprise’s operating income and invested capital, since the early 1990s, residual income has come to be called economic profit or Economic Value Added (EVA®).


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Economic Profit

  • Economic profit (EP) starts with the amount of capital that is invested at the beginning of the period.

  • EP = NOPAT – capital charge

  • EP = NOPAT – (WACC)(invested capital)


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Residual Income is…

  • an accounting measure and can, therefore, be manipulated for any one period.

  • an income-based compensation system that provides an incentive for the management to allocate capital efficiently over time.

  • is dependent on an accurate estimate of the cost of capital, no simple task.


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Residual Income is…

  • not economic income, despite the name given to some forms of residual income. A firm’s economic income is equal to net cash flows plus a change in present value or market value of the firm.

  • surprisingly, not as strongly correlated with the total return to shareholders as one would expect.


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Risk and Return

  • Efficient-Markets Hypothesis (EMH)

  • Portfolio Diversification

  • Capital Asset Pricing Model (CAPM)


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Price/Share

Time

Efficient-Markets Hypothesis (EMH)

  • Information content: when an item of information causes a price response in the security

  • Three forms

    • Weak

    • Semistrong

    • Strong


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Portfolio Theory

  • Risk can be reduced by holding a portfolio of investments

  • Risk types

    • Unsystematic (diversifiable)

    • Systematic (undiversifiable)


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Portfolio Risk

(standard deviation)

Number of Securities

Portfolio Diversification


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Capital Asset pricing Model (CAPM)

  • Theoretical pricing of stocks

  • Market assumed to be a diversified portfolio

  • Correlation made between returns on individual stocks and market returns

  • Regression analysis fits a line to the scattergraph

  • Slope of the characteristic line is beta


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Value of Accounting Information

  • Information Contents of Earnings Announcements

  • Market Reaction to Alternative Accounting Policies

  • Accounting Alternatives and Cash Flow

  • The Incomplete Revelation Hypothesis


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Information Content of Earnings Announcements

+

Return on Stock

Return on Market

Characteristic Line

-


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Rj

= expected return on security j

i

= risk-free rate of return

Rm

= expected return on the market portfolio

Rj = i + Bj (Rm – i)

Bj

= beta coefficient for security j


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aj

= the intercept from the regression

ej

= random error term

Rj = aj + Bj (Rm) + ej

Empirical studies in accounting use an approach referred to as the market model


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Unexpected or Abnormal Returns

  • Captured in the error term ej

  • A common research approach is to regress these abnormal returns on accounting variables such as unexpected reported earnings for the same time period to determine if there is information content


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Market Reaction to Alternative Accounting Policies

  • Research has found that security prices respond to accounting income numbers.

  • Alternative accounting methods affect reported earnings; however, there is no systematic effect on company cash flows.

  • Accounting alternatives simply represent different patterns of expense recognition or cost allocations.


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Accounting Alternatives and Cash Flow

  • Accounting policy changes with no apparent underlying changes in cash flow have no information content.

  • LIFO, a choice with cash flow consequences in the USA, may have information content (studies mixed over the years).

  • More recent security-price research has led to indirect consequences studies.


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Anomalies

  • Fundamental analysis, study by Ou and Penman

  • Low Correlation between Earnings and Stock Returns, study by Lev

  • Post-Earnings-Announcement Drift, multiple studies

  • Mispricing Related to Accruals,study by Richardson, Sloan, Soliman, and Tuna


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Difficult to extract disclosure

some accounting numbers or relationships are more difficult or costly to uncover and their effects may not be fully revealed in security prices

This is contrary to the EMH assumption

Noise traders

individuals who do not necessarily respond in a completely rational way in terms of responding to new information in terms of their trading habits

may be rebalancing their portfolios, responding to liquidity shocks or even acting upon whims

Incomplete Revelation Hypothesis


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Summary of the relationship between accounting data and unexpected changes in stock prices, measured as abnormal returns

  • Accounting earnings appear to have information content and to affect security prices

  • Alternative accounting policies with no apparent cash flow consequences have no information content

  • Alternative accounting policies with cash flow consequences do have information content

  • Security markets do not react fully and instantaneously to certain types of accounting data in certain situations (e.g., high accruals, small stocks, low analyst coverage)

  • There are incentives to choose certain accounting policies, where choice exists, owing to indirect cash consequences.

  • Accounting-based risk measures correlate with market risk measures, suggesting that accounting numbers are useful for risk assessment.


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Another research approach unexpected changes in stock prices, measured as abnormal returns

  • Examine the association between accounting data reported in the financial statements and the levels of stock prices (not the abnormal returns)

  • Referred to as cross-sectional valuation


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Value of Accounting Information: unexpected changes in stock prices, measured as abnormal returnsEvidence from Cross-Sectional Valuation

  • Pensions, a firm’s pension plan assets and liabilities (as reported off-balance sheet in footnote disclosures) are consistent with their being viewed as on-balance sheetassets and liabilities, respectively

  • Research & Development, the market interprets R&D as an asset (investment) rather than an expense

  • Financial Services, banks’ supplemental disclosure of the fair market value of investment securities is associated with market value over and above that explained by historical costs alone.


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Accounting Data and Creditors unexpected changes in stock prices, measured as abnormal returns

  • Predicting corporate bankruptcy (loan default)

  • Credit ratings, including bond ratings and default risk premiums

  • Sensitivity of loan-related decision making to key accounting data, experimental studies support


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Earnings Forecasting unexpected changes in stock prices, measured as abnormal returns

  • While the value of the firm is equal to the present value of the future expected cash flows, earnings appear to play an important role in predicting those cash flows.

  • Over the years, the relationship between earnings and stock prices has diminished.

    • However, the ability of earnings to forecast future cash flows has not. Kim and Kross examine the ability of earnings to forecast one-year ahead operating cash flows by examining three decades of data (1972-2001).

    • Their findings are positive


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Empirical Research and Standard Setting unexpected changes in stock prices, measured as abnormal returns

  • Can empirical research aid standard setting?

    • Holthausen and Watts say “no”

    • Barth, Beaver, and Landsman say “yes”

  • The difference between the two positions involves an empirical issue, which is presently unresolved: the multiple user group problem


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Lecture Recap unexpected changes in stock prices, measured as abnormal returns

  • Earnings, Dividends, and Stock Prices

  • Residual Income Models

  • Risk and Return

    • Efficient-Markets Hypothesis

    • Capital Markets Research in Accounting

  • Value of Accounting Information

    • Evidence from Return Data

    • Evidence from Direct Valuation

  • Accounting data and creditors

  • Earnings Forecasting

  • Empirical Research and Standard Setting


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