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
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306-684 Financial Accounting
Seminar 4 – the Information
Perspective on Decision Usefulness
Semester 2, 2009
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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
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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.
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Learning objectives cont.
• Key terms/concepts for the week:
• market model
• abnormal returns
• event study (and associated difficulties)
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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.
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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?
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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
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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)
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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
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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
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Market response studies
• How do we set up a study that tests
decision usefulness???
• Decide on observation window
• Identify expected return
• Determine market response
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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
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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
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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
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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
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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...
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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
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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
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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
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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?
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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
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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’
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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?
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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
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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
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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
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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
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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!
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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
Semester 2, 2009
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