Financial Accounting Theory
Craig Deegan
Chapter 10
Reactions of capital markets to financial
reporting
Slides written by Craig Deegan and Michaela
Rankin
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-1
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 looks
at the information content of accounting disclosures, and
capital market research that uses share price data as a
benchmark for evaluating accounting disclosures
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-2
Learning objectives (cont.)
– 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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PPTs t/a Financial Accounting Theory 2e by Deegan
10-3
Capital market research—introduction
• Explores the role of accounting and other financial
information in equity markets
• Involves examining statistical relations between
financial information and share prices
• Reactions of investors evident from capital market
transactions
• No share price change implies no reaction to
particular information
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-4
Capital market versus behavioural
research
• Capital market research
– assesses the aggregate effect of financial reporting on
investors
– considers only investors
• Behavioural research
– analyses individual responses to financial reporting
– examines decision-making by many groups
 e.g. bank managers, loan officers, auditors
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-5
Reasons for capital market research
• Information about earnings and its components is
the primary purpose of financial reporting
• Earnings are oriented towards the interests of
shareholders
• Earnings is the number most analysed and
forecast by security analysts
• Reliable data on earnings is readily available
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-6
Underlying assumption of CMR—EMH
• CMR relies on the assumption that equity markets
are efficient
– in accordance with Efficient Market Hypothesis (EMH)
• Efficient market defined as a market that adjusts
rapidly to fully impound information into share
prices when the information is released
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-7
Three forms of market efficiency
• Weak form: prices reflect information about past
prices and trading volumes
• Semi-strong form: all publicly available information
is rapidly and fully impounded into share prices in
an unbiased manner when released
– most relevant for accounting-based capital market
research
• Strong form: security prices reflect all information
(public and private)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-8
Market efficiency—implications for
accounting
• If markets are efficient they will use information
from 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-9
Earnings/return relation
• Share prices are the sum of expected future cash
flows from dividends, discounted to their present
value using a rate of return commensurate with the
company’s risk
• Dividends are a function of accounting earnings
• Unexpected earnings rather than total earnings
expected to be associated with a change in share
price
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-10
Earnings/return relation—market model
• Used to separate out firm-specific share price
movements from market-wide movements
– derived from the Capital Asset Pricing Model
• Assumes investors are risk averse and have
homogeneous expectations
• Its use allows the researcher to focus on share
price movements due to firm-specific news
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-11
Earnings/return relation—market model
(cont.)
• Total or actual returns can be divided into
– normal (expected) returns given market-wide movements
– abnormal (unexpected) returns due to firm-specific share
price movements
• Abnormal returns used as an indicator of
information content of announcements
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-12
Results of CMR—Ball 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-13
Results of CMR—extent of alternative
information sources
• Information content varies between countries and
companies
• Compared to US markets, Australian market had
slower adjustments during the year with larger
adjustments 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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PPTs t/a Financial Accounting Theory 2e by Deegan
10-14
Results of CMR—permanent and
temporary changes
• Research examined relationship between the
magnitude of unexpected changes in earnings
(EPS) and magnitude of abnormal returns
– known as the earnings response coefficient
– 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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PPTs t/a Financial Accounting Theory 2e by Deegan
10-15
Results of CMR—relative magnitudes of
cash and accruals
• Earnings persistence depends on proportion of
accruals 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-16
Results of CMR—information
announcements of other firms
• Earnings announcements by one firm also results
in abnormal returns to other firms in the same
industry
• Related to whether the news reflects a change in
conditions for the entire industry, or changes in
relative market share within the industry
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-17
Results of CMR—information content of
earnings forecasts
• Announcements of expected earnings rather than
actual earnings are associated with share returns
• Management and security analysts both make
forecasts
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PPTs t/a Financial Accounting Theory 2e by Deegan
10-18
Results of CMR—benefits of voluntary
disclosure
• Voluntary disclosures include those in annual
reports as well as media releases etc.
• Firms with more disclosure policies have
– larger analyst following and more accurate analyst
earnings forecasts
– increased investor following
– reduced information asymmetry
– reduced costs of equity capital
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-19
Results of CMR—recognition versus
footnote disclosure
• Recognising an item in the financial statements is
perceived differently to disclosure in footnotes
• Investors place greater reliance on recognised
amounts than on disclosed amounts
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PPTs t/a Financial Accounting Theory 2e by Deegan
10-20
Results of CMR—size
• Relationship between earnings announcements
and share price movements is inversely related to
the size of the entity
• Earnings announcements found to have a greater
impact on share prices of smaller firms than larger
firms
• More information generally available for larger
firms
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PPTs t/a Financial Accounting Theory 2e by Deegan
10-21
Do current prices anticipate future
announcements?
• As firm size increases, share prices incorporate
information 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Accounting Theory 2e by Deegan
10-22
Accounting earnings reflecting
information
• Rather than determining whether earnings
announcements 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
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PPTs t/a Financial Accounting Theory 2e by Deegan
10-23
Accounting earnings reflecting
information (cont.)
• Share prices are considered as benchmark
measures of firm value
• Share returns are considered as benchmark
measures of firm performance
• Benchmarks are then used to compare usefulness
of alternative accounting and disclosure methods
• Based on premise that market values and book
values are both measures of firm value
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PPTs t/a Financial Accounting Theory 2e by Deegan
10-24
Accounting earnings reflecting
information (cont.)
• If market value is related to book value, returns
should 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
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PPTs t/a Financial Accounting Theory 2e by Deegan
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Results of CMR—accounting earnings
reflecting information
• Beaver, Lambert and Morse (1980) found share
prices and related returns were related to
accounting earnings
• Because of various information sources, price
appeared to anticipate future accounting earnings
• Supported by Beaver, Lambert and Ryan (1987)
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PPTs t/a Financial Accounting Theory 2e by Deegan
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Results of CMR—accounting earnings
reflecting information (cont.)
• Dechow (1994) found over short intervals earnings
are 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
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PPTs t/a Financial Accounting Theory 2e by Deegan
10-27
Results of CMR —accounting earnings
reflecting information (cont.)
• Studies examining which asset value approaches
provide accounting figures that best reflect market
valuation found
– fair value estimates of bank’s 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)
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PPTs t/a Financial Accounting Theory 2e by Deegan
10-28
Relaxing assumptions about market
efficiency
• Recent years have seen a number of researchers
questioning 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 ‘underreact’ to particular announcements
• Created new areas for research—for example
what factors influence ‘earnings drift’
• So, should we reject research that has embraced
the EMH?
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PPTs t/a Financial Accounting Theory 2e by Deegan
10-29