Chapter 5

Copyright © 2009 by Pearson Education Canada5 - 1

Chapter 5The Information Approach to Decision Usefulness

Copyright © 2009 by Pearson Education Canada5 - 2

Chapter 5The Information Approach to Decision Usefulness

Copyright © 2009 by Pearson Education Canada 5 - 3

The Information Approach

• Assumes securities market efficiency• Investors responsible for predicting future firm

performance– Role of financial reporting to provide useful information

for this purpose

• Usefulness of financial information evaluated by magnitude of security price response to that information


5.2.1 Reasons for Security Price Response

• An application of decision theory model– Investors have prior probabilities of future firm

performance– Investors obtain useful information from financial

statements– Investors revise their probabilities– Leads to buy/sell decisions– Security price changes– Return on share changes


Abnormal Share Return

• Total share return = return due to market-wide factors ± abnormal share return due to firm-specific factors– Only abnormal share return can be attributed to

financial accounting information– If good news in financial statements leads to positive

abnormal share return (and vice versa), conclude financial statement information is useful.

– To reach such a conclusion, need to separate market-wide and firm-specific returns


5.2.3 Separating Market-Wide and Firm-Specific Factors

• Firm releases financial information– Most studies look at release of earnings

• Use market model to estimate market-wide return on that day (or narrow window)– Assumes market efficiency

• Abnormal share return during narrow window = total return – market-wide return

• See Figure 5.2 for details

» Continued


5.2.3 Separating Market-Wide and Firm-Specific Factors (continued)


Unexpected Earnings

• Investors have expectations of current earnings• Investors’ expectations are built into share price

prior to release of current earnings– Assumes market efficiency

• Investors will react only to unexpected earnings• Investors’ earnings expectations unobservable

– How to separate expected and unexpected earnings?


Estimation of Investors’ Earnings Expectations

• Time series approach– Based on earnings in prior years

• Analysts’ forecasts– Available for most large firms– Now the most common approach


5.3 The Ball and Brown Study

• The First Study to Document Statistically a Share Price Response to Reported Net Income (1968)

• Methodology Still in Use Today


B&B Methodology

• For Each Sample Firm:– Estimate investors’ earnings expectations (proxied by

last year’s actual)– Classify each firm as GN (actual earnings > expected

earnings) or BN (vice versa)– Estimate abnormal share return for month of release of

earnings (month 0), using procedure of Figure 5.1

» Continued


B&B Methodology (continued)

• Calculate Average Abnormal Share Return for GN Firms for Month 0

• Ditto for BN Firms• Repeat for Months -1, -2,…,-11, and Months +1,

+2,…,+6• Plot Results

– See Fig. 5.3, next slide


B&B Results


B&B Conclusion

• Stock Market Reacts to Accounting Information, but Begins to Anticipate the GN or BN in Earnings 12 Months Prior to Month of Earnings Announcement– Consistent with securities market efficiency and

underlying rational decision theory


5.3.2 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

• Narrow window studies more consistent with decision usefulness


5.3.3 Research in Years Following Ball & Brown

• Does Amount of Abnormal Share Price Change Correlate With Amount of GN/BN? Yes

• With Quarterly Earnings Reports? Yes• On Other Stock Markets? Yes• Response to Balance Sheet Information? Hard to

Find


5.4 A Different Question

• Earnings Response Coefficients (ERC)– Do characteristics of unexpected earnings affect

magnitude of abnormal share return? Yes


5.4.1 Factors Affecting ERC

• Risk (ß): higher ß lower ERC• Capital structure: higher D/E lower ERC• Earnings quality: higher quality higher ERC

– Earnings persistence: higher persistence higher ERC

» Continued


5.4.1 Factors Affecting ERC (continued)

• Growth opportunities: higher opportunities, higher ERC

• Similarity of investor expectations: more similar, higher ERC

• Informativeness of price: more informative, lower ERC?


More On Earnings Quality

• How to Measure?– Conceptual: main diag. probs. of info. system– Earnings persistence: higher persistence → higher quality

• Line-by-line evaluation (Ramakrishnan & Thomas (1991))

– Accruals quality (DeChow & Dichev (2002)): higher accruals quality → higher earnings quality


5.5 Unusual, Non-Recurring, and Extraordinary Items

• Hierarchy of income numbers

– Net income before unusual and non-recurring items, also called core earnings x x

– Unusual and non-recurring items x x

– Income from continuing operations, also called operating income x x

– Extraordinary items x x– Net income x x

» Continued


5.5 Unusual, Non-Recurring, and Extraordinary Items (continued)

• Definition of extraordinary item– Infrequent– Not typical– Do not depend primarily on decisions of managers or

owners

• If item is not extraordinary, it is part of operating income


A Financial Reporting Problem

• Manager motivation to put core earnings “in the bank” by overstating unusual, non-recurring, and extraordinary writeoffs

• Overstating writeoffs overstates future core earnings– Effect is to overstate earnings persistence, thereby

misleading investors– See Theory in Practice 11.1 re: Nortel


5.6 Accounting Information as a Public Good

• A public good is a good such that use by one person does not destroy it for use by another person

• Accounting information has public good characteristics– Use by one person does not prevent its reuse by others

• Thus firm cannot charge users for accounting information

» Continued


5.6 Accounting Information as a Public Good (continued)

• Investors who do not pay for accounting information will demand more of it than socially desirable

• Implication is that standard setters cannot be sure that an accounting policy that has a higher ERC than another is socially better.

• Complicates standard setting• Still true, though, that an accounting policy with

higher ERC is more useful to investors


Conclusion

• Security market response to accounting information supports rational decision theory and efficient securities market theory

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Chapter 5

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