DeeganFAT3e PPT Ch10-Ed

8/11/2019 DeeganFAT3e PPT Ch10-Ed

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10-1Copyright 2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e

Financial Accounting TheoryCraig Deegan

Chapter 10

Reactions of capital markets to financial

reporting

Slides written by Craig Deegan


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Learning objectives

In this chapter you will be introduced to: the role of capital market research (CMR) in assessing

the information content of accounting disclosures

the assumptions of market efficiency typically adopted in

capital market research

the difference between capital market research that looksat the information content of accounting disclosures, and

capital market research that uses share price data as a

benchmark for evaluating accounting disclosures

why unexpected accounting earnings and abnormal

share price returns are expected to be related the major results of capital market research into financial

accounting and disclosure


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Capital market researchintroduction

Explores the role of accounting and other financialinformation in equity markets

Involves examining statistical relations betweenfinancial information and share prices

Reactions of investors evident from capital markettransactions

No share price change implies no reaction toparticular information


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Capital market versus behaviouralresearch

Capital market research (the topic of this lecture) assesses the aggregate effect of financial reporting on

investors

considers only investors

Behavioural research (the topic of the next lecture)

analyses individual responses to financial reporting

examines decision-making by many groups

e.g. bank managers, loan officers, auditors


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Reasons for capital market research

Information about earnings and its components isthe primary purpose of financial reporting

Earnings are oriented toward the interests of

shareholders

Earnings is the number most analysed and

forecast by security analysts

Reliable data on earnings is readily available


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Underlying assumption of CMREMH

CMR relies on the assumption that equity marketsare efficient

in accordance with Efficient Market Hypothesis (EMH)

Efficient market defined as a market that adjustsrapidly to fully impound information into share

prices when the information is released


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Three forms of market efficiency

Weak form: prices reflect information about pastprices and trading volumes

Semi-strong form: all publicly available information

is rapidly and fully impounded into share prices inan unbiased manner when released

most relevant for accounting-based capital market

research

Strong form: security prices reflect all information

(public and private)


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Market efficiencyimplications foraccounting

If markets are efficient they will use informationfrom various sources when predicting future

earnings

If accounting information does not impact on share

prices then it is deemed not to have any

information value above that currently available


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Market efficiency share prices reactto information from various sources

For example, material provided within the textbookindicates that share prices have been found toreact not only to earnings data but also to suchthings as: News about senior executive resignations

Takeover rumours posted to internet discussion sites Which raises possible issues about the regulation of

information provided on such sites

Concerns raised by auditors, particularly in relation togoing concern considerations (unless anticipated by themarket)

Industry-wide changes, such as the implicationsassociated with the introduction of particular legislations(such as the Sarbanes-Oxley Act in the US)


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Earnings/return relation

Share prices are the sum of expected future cashflows from dividends, discounted to their present

value using a rate of return commensurate with the

companys risk

Dividends are a function of accounting earnings

Unexpected earnings rather than total earnings

expected to be associated with a change in shareprice


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Earnings/return relationmarketmodel

Used to separate out firm-specific share pricemovements from market-wide movements

derived from the Capital Asset Pricing Model

Assumes investors are risk averse and havehomogeneous expectations

Its use allows the researcher to focus on share

price movements due to firm-specific news


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Results of CMRBall and Brown(1968) study

Examined data from 261 US firms Tested whether firms with unexpected increases in

accounting earnings had positive abnormal

returns, and firms with unexpected decreases had

negative abnormal returns

Found that

information contained in the annual report, prepared

using historical cost was useful to investors

85 to 90% of earnings announcement is anticipated by

investors much of information is obtained from other sources


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Results of CMRextent of alternativeinformation sources

Information content varies between countries andcompanies

Compared to US markets, Australian market had

slower adjustments during the year with largeradjustments at earnings announcement

less alternative sources of information for Australian

market

Less alternative sources of information for smaller

firms than larger firms


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Results of CMRpermanent andtemporary changes

Research examined relationship between themagnitude of unexpected changes in earnings

(EPS) and magnitude of abnormal returns

known as the earnings response coefficient

Some research has shown that a 1% unexpected change

in earnings associated with 0.1 to 0.15% abnormal return

depends on whether earnings increases expected to be

permanent or temporary


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Results of CMRrelative magnitudesof cash and accruals

Earnings persistence depends on proportion ofaccruals relative to cash flows

firms with large accruals relative to actual cash flows

unlikely to have persistently high earnings

Share prices found to act as if investors fixate on

reported earnings without considering relative

magnitudes of cash and accrual components


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Results of CMRinformationannouncements of other firms Earnings announcements by one firm also results

in abnormal returns to other firms in the sameindustry

Related to whether the news reflects a change inconditions for the entire industry, or changes inrelative market share within the industry

For example, if an organisation within an industryis the first to prepare its financial results for theyear, and it reports record profits that wereunexpected by the market, then this would often

cause share price increases across the industry For example, Accounting Headline 10.6 shows that whenCBA reported record profits this was followed by shareprice increases in other banks even prior to their earningsannouncements


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10-19Copyright

2009 McGraw-Hill Australia Pty LtdPPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMRinformation contentof earnings forecasts

Announcements of expected earnings rather thanactual earnings are associated with share returns

Management and security analysts both make

forecasts


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Results of CMRbenefits ofvoluntary disclosure

Voluntary disclosures include those in annualreports as well as media releases etc.

Firms with more disclosure policies have

larger analyst following and more accurate analystearnings forecasts

increased investor following

reduced information asymmetry

reduced costs of equity capital


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Results of CMRrecognition versusfootnote disclosure

Recognising an item in the financial statements isperceived differently to disclosure in footnotes

Investors place greater reliance on recognised

amounts than on disclosed amounts


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Results of CMRsize

Relationship between earnings announcementsand share price movements is inversely related to

the size of the entity

Earnings announcements found to have a greaterimpact on share prices of smaller firms than larger

firms

More information generally available for largerfirms


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Results of CMRunexpected changes inearnings vs. unexpected changes in expenses

If earnings surprises are accompanied byrevenue surprises of similar magnitude in thesame direction, then the earnings surprises aredriven by revenue growth rather than by areduction in expenses.

Researchers expect earnings growth driven byrevenue growth to exhibit a different level ofpersistence compared with earnings growth drivenby expense reduction.

Jegadeesh and Livnat's (2006) results indicate that

the market does tend to react more to unexpectedearnings when these 'surprises' are due toincreases in revenues.

D i i i f


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Do current prices anticipate futureannouncements?

As firm size increases, share prices incorporateinformation from wider number of sources

relatively less unexpected information when earnings are

announced

May be able to argue that share prices anticipate

future earnings announcements for larger firms

with some accuracy

A ti i fl ti


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Accounting earnings reflectinginformation

Rather than determining whether earningsannouncements provide information, recent

research examines whether earnings

announcements reflect information that has been

already used by investors

looking back the other way

market prices viewed as leading accounting earnings

A ti i fl ti


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Accounting earnings reflectinginformation (cont.)

Share prices are considered as benchmarkmeasures of firm value

Share returns are considered as benchmarkmeasures of firm performance

Benchmarks are then used to compare usefulnessof alternative accounting and disclosure methods

Based on premise that market values and bookvalues are both measures of firm value

A ti i fl ti


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Accounting earnings reflectinginformation (cont.)

If market value is related to book value, returnsshould be related to accounting earnings per

share, divided by price at the beginning of the

accounting period

provides an underlying reason why we should expect

returns to be related to earnings over time

R lt f CMR ti


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Results of CMRaccountingearnings reflecting information

Beaver, Lambert and Morse (1980) found shareprices and related returns were related to

accounting earnings

Because of various information sources, priceappeared to anticipate future accounting earnings

Supported by Beaver, Lambert and Ryan (1987)


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Results of CMRaccounting earningsreflecting information (cont.)

Dechow (1994) found over short intervals earningsare more strongly associated with returns than are

realised cash flows

the ability of cash flows to measure firm performance

increases as the measurement interval increases

f C


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10-30Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR accounting earningsreflecting information (cont.)

Studies examining which asset value approachesprovide accounting figures that best reflect market

valuation found:

fair value estimates of banks financial instruments seem

to provide a better explanation of bank share prices than

historical cost (Barth, Beaver & Landsman 1996) revaluation of assets results in better alignment of market

and book values (Easton, Eddy & Harris 1993)

R l i ti b t k t


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10-31Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e

Relaxing assumptions about marketefficiency

Recent years have seen a number of researchersquestioning some assumptions about market

efficiency

Market reactions to information often found to be

longer than would be anticipated from an efficient

market. Also market found to sometimes under-

react to particular announcements

Created new areas for researchfor example

what factors influence earnings drift

So, should we reject research that has embraced

the EMH?

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