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Chapter 5: The Information Approach to Decision Usefulness

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1 Chapter 5: The Information Approach to Decision Usefulness
Ari Benarroch Nazish Haq Qin Lin Nikhil Sequeira

2 Agenda Overview of the chapter Outline of research problem
The Ball and Brown Study Earnings Response Coefficients Unusual, Non-Recurring, and Extraordinary Items The “Best” accounting policy

3 Overview Accounting research shows that security prices do respond to accounting information The ball and brown in study in 1968 provides the first solid evidence of a securities market reaction to an earnings announcement In essence information is useful if it changes investor beliefs The purpose of this chapter is to show that accounting information is useful for decision making. Over the years accounting research has shown that security prices do respond to accounting information, the first evidence of this was provided by the Ball and Brown study in 1968. Since this initial study there have been a lot of other studies that have documented additional aspects of security market response If accounting information was not useful for decision making then when users receive this information there would be no revision of beliefs hence no triggering of buy/sell decisions. Which means there would be no trading volume or price changes, but this is not the case In essence information is useful if it changes investor beliefs which means it leads to buy/sell decisions which leads to price changes

4 Definition The information approach to decision usefulness is an approach that recognizes individual responsibility for predicting future firm performance and that concentrates on providing useful information for this purpose. The approach assumes security market efficiency recognizing that the market will react to useful information from any source, including financial statements This leads in the above definition Can anyone tell me what it implies about investors and accountants??

5 What does this mean? Investors want to make their own predictions
Research can help accountants determine what information is useful Investors want to make their own predictions on the future of security returns and will use all the information available to do this. This is useful accountants to help increase the usefulness of information by letting market response tell them what information is valued by investors. This will help improve their competitive position in the information marketplace by providing useful information

6 Example On March 31st 2010 Research in Motion Limited (TSE:RIM) reported earnings of US$4.02 Billion. The expected earnings were $4.18 Billion. What was the effect on RIM share price that day? RIM share price falling on march 31st 2010, fell by around 10% despite the fact that they have strong growth

7 Outline of Research Problem
Predictions about investor behaviour: Investors have prior beliefs about firms future performance When current income is released some investors will decide to become more informed by analyzing the income number Buy more shares if believe firm’s performance will increase and sell shares if believe firms performance will decline Volume of shares traded is expected to increase when firm reports net income. To determine what information is useful in predicting market price of a firms share we will need to make certain predictions about investor behaviour. We need to keep in mind for this chapter we use only net income as a source of financial information

8 Finding Market Response
Efficient market theory implies that the market will react quickly to new information Good or bad news is evaluated relative to what investors expected There are multiple events that affect a firms share price, so finding the effect of net income can be hard Efficient market should react within a narrow window of a few days surrounding the net income announcement date. Researchers use the date income was reported by financial media such as the Wallstreet journal to avoid looking at the volume of shares traded too late or too early. Use MD&A Have to separate firm specific and market wide factors that affect share price

9 Separating Market Wide and Firm Specific factors
Alpha is the return on the market on a particular day (Day 0) which is This means that the expected return is for firm J, however the actual return was This difference of is an abnormal return (the e symbol) or firm specific return for firm j shares on that day

10 Comparing Returns and Income
If income announcement is good news then we have a positive abnormal share return Vice versa for bad news income announcement

11 The Ball and Brown Study
The study was the first to provide convincing scientific evidence that firm’s share returns respond to reported net income. This type of research is called an event study. Methodology is still in used today.

12 Methodology of B&B Study
The First Task: Use last year’s actual earnings as a proxy for the market expectation. Classify as GN: Actual earnings > Expected earnings Classify as BG: Actual earnings < Expected earnings The Second Task Estimate abnormal share return near the time of each earnings announcement (month 0), by using procedure illustrated in Figure 5.2

13 Figure 5.3 Abnormal Returns for GN and BN Firms

14 B&B Conclusion Stock market reacts to accounting information, but begins to anticipate the GN or BN as much as a year early. The important in distinction between narrow and wide window studies. Narrow window: a few days up to one month Wide window: longer than one month

15 Causation Vs. Association
Narrow Window Study: The accounting information is the cause of the market reaction Wide Window Study: The accounting information is associated with the market reaction Prices lead earnings over a wide window Narrow Window study provides stronger support for decision usefulness.

16 Research Paper “ The Effect of CEO ownership on the information content of Reported Earnings” By: Aloke Ghosh, Doocheol Moon. This paper examines the relation between capital market perceptions of earnings quality and CEO Equity ownership. The research concludes that the earnings response coefficients (ERCs) decline across higher levels of CEO ownership with an inflection point around 25% ownership. The result suggests that, for low levels of CEO ownership, earnings are more informative about future firm performance

17 Questions Q1. Does amount of abnormal share price change correlate with: Amount of GN/BN? Yes/No With Quarterly Earning Reports? Yes/No Q2. Narrow window studies show that financial statement information is associated with security price change. True/False

18 Efficient Response Coefficient (ERC)
Why do movie go-ers respond to changes in movie opening dates? Study by: Linar Einav and Abraham Ravid

19 Efficient Response Coefficient (ERC)
Measures the extent of a securities abnormal market return in response to the unexpected component of reported earnings of the firm issuing that security

20 Reasons for Differential Market Response
Beta: if the firms earnings are risky, the value to a risk adverse investor will be lower = lower ERC The opposite is true for a diversified investor Investors will react less to a security with very risky future returns

21 Reasons for Differential Market Response
Capital Structure: an increase in earnings adds strength/safety to a bond holder or other debt holder = lower ERC “Good” news goes to a debt holder instead of a shareholder Earnings Quality: the higher the persistency of changes in unexpected earnings changes, the higher the ERCs

22 3 Types of Earning Events
1) Permanent: expected to last indefinitely 2) Transitory: affecting earrings in the current year only 3) Price Irrelevant: zero persistency

23 Reasons for Differential Market Response
Growth Opportunities: current good news in earnings suggest growth opportunities = higher ERC Similarity of Investor Expectations: a common info source for investor’s will create more similarities in their interpretation of a firm’s next period earnings = higher ERC The more precise the analysts’ forecasts the more similar an investors’ earnings expectations

24 Reasons for Differential Market Response
Informativeness of Price: the more informative the price, the less informative the content of current accounting earnings = lower ERC

25 Unusual, Non-Recurring , Extraordinary Items
Extraordinary Items Characteristics (All are required to be considered extraordinary) 1. They are not expected to occur frequently or over several years 2. They do not typify the normal business activities of the entity 3. They do not depend primarily on decisions or determinations by managers or owners

26 Classificatory Smoothing
Definition: Management would choose to classify unusual items above or below the operating earnings line; a.k.a smoothing out earnings. Characteristic 3 (from previous slide) was put into place for this reason in 1989

27 2 Problems from Section 3480 1) Overestimate the persistence of operating income, due to the fact that unusual and non-recurring items are not fully disclosed. 2) Amounts and timing of unusual and non-recurring items are subject to strategic manipulation by management. Ex: If management chooses to recognize an unusual loss currently, income from continuing operations is reduced. If this occurs over many years then previous years earnings can be overstated.

28 Theory in Practice Have we improved financial reporting with Section in place? Many companies were incurring substantial expenses and revenue losses due to the September 11th terrorist attacks. Ex: Airlines were unable to fly for two days FASB did not allow attacks to be considered extraordinary because it was too hard to differentiate between direct costs (loss of revenue for the 2 day shut down period) and indirect costs ( consumer fear of flying for safety reasons).

29 5.6 A Caveat About the “Best” Accounting Policy
Public Good: A good such that consumption by one user does not affect the use of it for another user, whereas a private good eliminates the usefulness for other consumers. Ex: More than one investor can use annual reports without affecting another investor. It’s hard to charge for such products because it wouldn’t attract many consumers. One annual report can be distributed to many users. Because of this public goods are often supplied by governmental or quasi-governmental agencies.

30 THE END ?

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