Chapter 8: Usefulness of Accounting Information to Investors and Creditors
Firm valuation models
Efficient-markets hypothesis
CAPM
Cross-sectional valuation studies
Company-auditor roles
Accounting data and creditors
Accounting allocations
Information economics
Financial Accounting Standards Board
Primary user groupsInvestors
Creditors
Cost-Benefit calculusCost considerations confined to producers
Benefits for investors and creditors
Firm Valuation Models
Dividend valuation model: value of a firm is the present value of future expected dividends to be received by stockholders
Cash flow valuation model: value of firm is the present value of future net cash flows
Theoretical literature implications are that accrual accounting systems incorporate the attribute that determines firm valuation...net cash flow data.
Efficient-Markets Hypothesis
Information content: when an item of information causes a price response in the security
Three formsWeak
Semistrong
Strong
Foundation of Capital Market ResearchPortfolio Theory
Risk can be reduced by holding a portfolio of investments
Risk typesUnsystematic (diversifiable)
Systematic (undiversifiable)
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
Security Returns vs. Market Returns
Return on Stock
Return on Market
Characteristic Line
+
-
Rj = expected return on security j
i = risk-free rate of return
Rm = expected return on the market portfolio
Bj = beta coefficient for security j
Rj = i + Bj (Rm – i)
Empirical studies in accounting use a simpler approach called the market model
Rj = α j + Bj (Rm) + ej
αj = the intercept from the regression
ej = random error term
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
Ball and Brown (1968)
Information content of accounting numbers
Seminal study showed the direction of change in reported earnings was positively correlated with security price movements
Not surprising...expect accounting income to be part of the information used by investors in assessing risk and return
Capital Market Research
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
Capital Market Research
Incentives exist 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
Another research approach
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
Company-Auditor Roles
Key assumption of accounting research is that financial statement information is reliable...GAAP applied on consistent basis
Jointly produced by company and auditorDemand can be explained by agency theory
Auditor researchQualified audit report leads to lower stock priceBig Six audits more highly valued
Accounting Data and Creditors
Predicting corporate bankruptcy (loan default)
Bond ratings
Interest-rate risk premiums on debt
Experimental studies of the role of accounting data in lending decisions
Usefulness of Accounting Allocations
Revenue recognition and the matching of costs to revenues over multiple accounting periods requires use of allocations
Criticized as arbitrary, no allocation is completely defensible against other methods
No evidence to support the contention that allocation-based financial statements are useless
Accounting Information Evaluation
Information economics, decision theoryDoes not provide answers to normative questionsCan determine only the value of specific information for a narrowly defined decision
LimitationsReal world decision makers face more complex decisionsUser diversity is an issue; behaviors may vary
Chapter 8: Usefulness of Accounting Information to Investors and Creditors
Firm valuation models
Efficient-markets hypothesis
CAPM
Cross-sectional valuation studies
Company-auditor roles
Accounting data and creditors
Accounting allocations
Information economics