Chapter 5: The Information
Approach to Decision Making
Overview
• This chapter answers the question:
• Do security market prices respond to
accounting information?
• A number of studies were completed to
answer this question
• Ball and Brown study from 1968
Overview Cont’d
• The information approach is the equating
of usefulness to information content
• Investors want to make their own predictions
rather than have accountants do it for them
• Information is useful if it leads investors to
change their beliefs and actions
• The degree of usefulness can be measured
by the extent of volume or price change
following the release of information
Does Disclosure Matter
• Does releasing lots of information help
stakeholders make more informed
decisions and help to better gage the
value of the firm? Or is it viewed as
unreliable since management is producing
the data?
• Are there dangers of disclosure?
Decision Making
• Deals with regulation standards on
environmental disclosure
• Most owners use information about
environmental disclosures to make
decisions
• The media plays a critical role to convey
non-financial information
Amount of Disclosure
• Convergence within industries to disclose
certain trends
• Canada faces less impact than other
countries such as Germany and France
• What is the ideal level of disclosure?
Reasons for Market Response
Consider the following predictions about
investor behaviour in response to financial
statement information:
1. Investors have prior beliefs about a firm’s
future performance
Reasons for Market Response
Cont’d
2. When the current period’s net income is
released, some investors will decide to become
more informed by analyzing the income number
3. Investors who have revised their beliefs
about future firm performance upwards, will buy
the firm’s shares at their current market price
4. Expect to observe the volume of shares
traded to increase when the firm reports its net
income
Reasons for Market Response
Cont’d
• A study was completed by Beaver, Clarke
and Wright which examined trading
volume reaction
• Found a dramatic increase in trading
volume during the week that earnings
announcements were released
Finding the Market Response
1. Efficient markets theory implies that the
market will react quickly to new information
2. The good or bad news in reported net
income is evaluated relative to what
investors expected
3. There are always many events taking place
that affect a firm’s share volume and price
Separating Market-Wide and
Firm-Specific Factors
Equation of the market model:
• Rjt= αj + βJRMt+εjt
• Rjt = Return on firm j’s shares for period t
• RMt = Return on market portfolio for period t
• εjt = firm specific return on j’s shares
Separating Market-Wide and
Firm-Specific Factors Cont’d
• Ror this equation researchers obtain
past data on Rjt and RMt
• Then use regression analysis to
estimate the coefficients of the model
• For example suppose:
• αj = 0.0001
• βJ = 0.80
Separating Market-Wide and
Firm-Specific Factors Cont’d
• The researcher must now consult the
financial media to identify the day of the
firm’s current earnings announcement
• Call this day “0”
• Suppose for this day the return on the Dow
Jones Industrial Index was 0.001
Separating Market-Wide and
Firm-Specific Factors Cont’d
• Next the estimated market model for firm j is
used to predict the return on firm j’s shares for
that day
• Expected return = 0.0001 + (0.80 x 0.001)
= 0.0009
Separating Market-Wide and
Firm-Specific Factors Cont’d
• Assume the actual return on firm j’s shares
for day 0 is 0.0015
• The difference between actual and
expected is 0.0006 (εjt )
• This number is an estimate of the
abnormal, or firm-specific, return on firm j’s
shares for that day
Separating Market-Wide and
Firm-Specific Factors Cont’d
• Graphical illustration of the market model
for firm j for period t
Comparing Returns and Income
• We can now compare the abnormal share
return on day 0 as calculated above with the
unexpected component of the firm’s current
reported net income
• If this unexpected net income is good news,
then given securities market efficiency, a
positive abnormal share return gives evidence
that investors, on average, are reacting
favourably to the unexpected good news in
earnings
Comparing Returns and Income
Cont’d
Difficulties with the methodology:
1. Other firm-specific information is frequently
released around the time as a firm’s earnings
announcement
1. The firm’s beta is an estimation
Ball and Brown Study Cont.
• Ball and Brown conducted the study in
1968
• The study was conducted on a sample of
261 NYSE firms in attempt to determine
market price response to earnings
information
Ball and Brown Study
• http://www.youtube.com/watch?v=_QDBX
9KfxHM&feature=relmfu
B&B - Methodology
• They determined abnormal return over
expected return and compared it to good
income performance (GN) or bad income
performance (BN) via a performance proxy
i.e. last year’s earnings compared to this
year’s earnings
• Observed results over a narrow window of
one month and a wide window of 18
months
B&B - Results
• Both narrow and wide windows related
good news to positive returns and bad
news to negative returns
• Noticed that when using the wide window,
the price of shares with positive income
news were already increasing prior to GN
release
• Study suggests that 85-90% of information
was already built into price by the time
earnings were announced
B&B - Results
B&B - Outcomes
• Since both wide and narrow windows related
good news with positive price changes and vice
versa with bad news we can conclude that
income news is only correlated with price
change, it does not cause the change
• Beaver, Clarke and Wright in 1979 extended the
study to examine the effects of the magnitude of
unexpected earnings and concluded that greater
unexpected earnings were correlated with
greater market response
Earnings Response Coefficients
• From the BB study we can see that on average good
news (“GN”) firms enjoyed abnormal returns and that bad
news (“BN”) firms showed negative returns
• Why does the market respond more strongly to good or
bad news in earnings reports for some firms than for
others?
• With the answer to this, accountants can improve
their understanding of how information is useful to
investors and in turn prepare more useful financial
statements
Earnings Response Coefficients
Cont’d
• Earnings Response Coefficient – measures the extent of
a security’s abnormal market return in response to the
unexpected component of reported earnings of the firm
issuing that security
• ERC = Abnormal Share Return / Unexpected
Earnings for Period
• Measures abnormal return per dollar of abnormal
earnings
Reasons for Differential Market
Response
1.
2.
3.
4.
5.
6.
Beta
Capital Structure
Earnings Quality
Growth Opportunities
The Similarity of Investor Expectations
The Informativeness of Price
Beta
• Recall: Beta measures the co-movement
between changes in the price of a security and
changes in the market value of the market
portfolio
• The riskier future returns are the lower
investors’ reactions to a given amount of
unexpected earnings will be
• Higher beta securities generally have lower
ERC’s
Capital Structure
• Increases in earnings add strength and
safety to bonds and other outstanding
debt so much of the GN in earnings goes
to the debt holders
• Highly levered firms generally have lower
ERC’s
Earnings Quality
• Recall: Quality of earnings is defined by the magnitude
of the diagonal probabilities of the associated
information system
• Thus the higher the probabilities are the higher the ERC
will be because investors are better able to infer future
firm performance from today's performance
• Problem: information system probabilities are not
directly observable
• Solution: Infer earnings quality by the magnitude of
analysts' earnings forecast revision announcement
Earnings Quality Cont’d
• Why do analysts adjust estimates more for some firms
than others?
• Earnings persistance
• Permanent, expected to persist indefinately
• Transitory, affecting earnings in current year but not
future years
• Price irrelevant, persistence of zero
• In effect there are three ERC's each of which could be
present in the same income statement
• Investors should attempt to identify the different types
separately and assign different ERC's to each rather
than trying to estimate an average
Earnings Persistence Example
Assess the earnings persistence for the following events
(Permanent, Transitory or Price irrelevant):
1. Unanticipated gain from disposal of equipment
2. A new technology is developed which is expected to
increase profits by 5% in perpetuity
3. The firm capitalizes a lot of organization costs
Earnings Persistence Example
Assess the earnings persistence for the following events
(Permanent, Transitory or Price irrelevant):
1. Unanticipated gain from disposal of equipment Transitory
2. A new technology is developed which is expected to
increase profits by 5% in perpetuity - Permanent
3. The firm capitalizes a lot of organization costs - Price
irrelevant - assuming organizational costs have no
salvage value
Earnings Quality Cont’d
• Second dimension of earnings quality is accruals quality
• Net Income = Cash Flow from Operations +/- Net Accruals
• Accruals include changes in non-cash working capital
accounts (AR, AFDA, AP, inventories etc.)
• High quality - accruals show up as cash flow the next
period
• Ex. If AR is $1,000 and AFDA is $100 and $900 is
collected the next period, the accruals are considered
high quality
Testing Accrual Quality
• DeChow and Dichev
Δ WCt = b0 + b1 CFOt-1 + b2 CFOt + b3 CFOt+1 + Et
Δ WC = change in net non-cash working capital
t = period
CFO = cash flow from operations in period t
b = constants that are to be estimated
E = residual error term (portion of total accruals
not explained by cash from operations)
Testing Accrual Quality Cont’d
Δ WCt = b0 + b1 CFOt-1 + b2 CFOt + b3 CFOt+1 + Et
• Data is used from several periods
• High E indicates a poor match between
current accruals and subsequent actual
operating cash flow realizations
• ERC and share price respond positively to
accrual quality
Growth Opportunities
• GN or BN may suggest future growth opportunities and
hence a higher ERC
• Ex. Recent projects display unexpected high profitability
• To assess growth often P/E shops and portfolio
managers analyze the ratio of market value of equity /
book value of equity
• The market will be aware of growth opportunities
before they are recognized in income thus driving
the stock price up
Growth Opportunities Cont’d
To better understand analyze a simple perpetuity:
• Calculate the present value of a 10 % perpetuity:
1/10% = $10
• Now assume the same perpetuity will grow by 5% per
year:
1/(10%-5%) = $20
Clearly the value increases when growth opportunities are
introduced
Similarities of Investor
Expectation
• Each investor will have a different expectations based on
the amount of available information to them and their
abilities to comprehend it
• However these differences are reduced since many
investors draw their information from similar sources –
analyst consensus forecasts etc.
• Depending on expectations they will interpret earnings
news as GN or BN but since most expectations are similar
they will generally have the same interpretation of the
news
• The more similar the expectations are the greater
the effect will be on the ERC
The Informativeness of Price
• Market price itself is partially informative about the future
value of the firm (leads)
• Market price includes all publicly known information
about the firm
• A more informative share price implies the market
anticipates changes in earnings power sooner
• The more informative the price the less informative
earnings releases will be and hence the firm will have a
lower ERC
Reasons for Differential Market
Response
• An increase in the following factors will
lead to:
Beta
Capital Structure
Earnings Quality
Growth Opportunities
Similarity of Investor Expectation
The Informativeness of Price
Effect on ERC
Lower
Lower
Higher
Higher
Higher
Lower
Questions
Assess the impact on the firm’s ERC:
1. A firm’s beta increases from 1 to 2.3
2. A firm pays off 20% of their debt
3. The firms quality of earnings falls
4. The return on recent projects that the
firm has been taking on have been
experiencing lower than historical
projects
Questions Cont’d
Assess the impact on the firm’s ERC:
5. Investors expectations become more
similar
6. Due to improved news coverage the
price becomes more informed
Implications of ERC Research
• Improved understanding of market responses allows
accountants to create and provide more useful information
to investors
• Capital structure – highly levered firms should have
lots of detail disclosing the nature and extent of all
liabilities
• Growth – the MD&A enables management to
communicate growth prospects
• Components of net income are important because
they allows investors to better interpret the earnings
number
Implications of ERC Research
Cont’d
• IAS 1 prohibits the use of extraordinary items in the
income statement and requires separate disclosure in the
notes for:
• Material write-downs and reversals thereof
• Restructuring provisions
• Gains and losses on provisions
• Other low-persistent items
• This puts considerable onus on the accountant to fully
disclose details of unusual, non-recurring and
extraordinary items
Measuring Investors’ Earnings
Expectations
• Must obtain a reasonable proxy for expected earnings
because the market will only react to the component of net
income they did not expect
• When conditions are not ideal earnings expectations are
more complex
• Ways to deal with this complexity:
• Time Series approach
• Analysts’ forecasts
Time Series Approach
• Analyze the persistence of past earnings to forecast
future earnings
• The two extremes of earnings persistence:
• Completely persistent – expected earnings for
current year are last year’s actual earnings and
estimated as the change from last year
• Zero persistence – no information from last year is
used and all earnings this year are unexpected
Analyst forecasts
• More accurate than time series forecasts
• Analysts interpret more information than past
earnings
• The age of a forecast has an important fact on its
accuracy
• The most recent earnings forecast provided a more
accurate earnings production than the average forecast of
all analysts following the firm (ignoring how old the
individual forecasts were)
• Timeliness dominates the cancelling-out-of-errors
effect of the average forecast
Summary
• The market is on average very sophisticated in its ability
to evaluate accounting information
• This supports the theory of securities market
efficiency and supports the decision usefulness
approach to financial reporting
• As accountants better understand investor response
they will be able to provide more useful information to
investors
The “Best” Accounting Policy
• Need to be careful to not only consider the
market
• Accounting information is a public good
• Accounting information should benefit
society overall
Other Financial Statement
Information
• Some supplementary information impacts the
market before annual reports are released
• It can often be difficult to determine when some
information is found out by the market, this
makes finding its impact more difficult
• Other financial statement and supplementary
information augments the market reaction to
earnings information
Bio-tech Article
• Expanding biotech industry is generating
large revenues in both Canada and USA
• Purpose is to test, develop and produce
drugs
• Large part of firms capital is raised through
public investment and is determined by
firms disclosure plan
Disclosure and Value
• Non-financial statements are key to
helping outside investors determine firm
value and decide where to invest
• Management can selectively disclose
information through various public
releases
Bio-tech Process
• Capital needed through stages of
development and testing
• Pre clinical > Investigational New Drug
Stage > Phase I clinical trial > Phase II
clinical trial >Phase III clinical trial > FDA
Final Approval
• Start with animals and move to humans
need approval at most stages to continue
testing and development
Investors
• Financial investors need to find present
value of cash flows but drug testing is a
long process with a lot of uncertainty
• Non-financial statements become
increasingly important
• Market value based on beliefs
• The study shows that investors reacted
more to non-financial information than
earnings information
Non Financial Disclosure
• Demonstrates that non-financial
information drives value more than
earnings information
•
•
•
•
Report to shareholders
Press releases
Web site disclosures
Regulatory filings
• Lag of stock price and accounting system
Conclusion
• Investors attempt to predict future events
using all forms of information
• Accountants must consider market response
in the preparation of accounting information to
stay competitive
• Research is done to determine the markets
response to information
• The more information accountants provide the
better the flow of resources in capital markets
Conclusion Cont’d
• Cannot only consider market reaction
• The market’s reactions are very
sophisticated
• Research supports the efficient markets
theory and decision theories
• Must make sure to disclose unusual and
nonrecurring events
Conclusion Cont’d
• Investors are more reactive to nonfinancial information than earnings
information, but still augments earnings
response
• The information approach has led lots of
research that has enhanced the decision
usefulness of accounting