Semester 2, 2009 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 AccountingSeminar 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