Chapter 3 Theoretical Context

Financial Information Analysis2 Copyright 2006 John Wiley & Sons Ltd Financial Analysis ‘Extracting significant information’ Purpose? Competitors: competitive advantage Owners: control Analysts: identify mis-priced shares Employees, Creditors: security Legitimate exercise? i.e., does it yield advantage?

Financial Information Analysis3 Copyright 2006 John Wiley & Sons Ltd Usefulness of analysis Can accounting info. satisfy these needs? Can analysis: aid control, identify advantage, etc.? What is role of accounting info? Is analysis viable, sustainable? If not, why proceed?

Financial Information Analysis4 Copyright 2006 John Wiley & Sons Ltd Theory of financial analysis Theory: explains predicts contextualises legitimises “What is relationship between accounting information and market?”

Financial Information Analysis5 Copyright 2006 John Wiley & Sons Ltd Theoretical approaches Objectivism ‘reality inherent in object’ Constructionism ‘reality is in interplay of object and subject’ Subjectivism ‘reality is in eye of beholder’

Financial Information Analysis6 Copyright 2006 John Wiley & Sons Ltd Accounting Theory Predominantly Objectivist Reality exists independently of experience Firm incorporates certain realities Reality can be measured society has given accountants ‘authority’ to devise rules to this end Measures can be interpreted Interpretation provides insights on reality

Financial Information Analysis7 Copyright 2006 John Wiley & Sons Ltd Classic (Normative) Theory Objectivist worldview 1950s-1960s Economic/Finance theory: financial instruments (shares) have intrinsic value financial accounts verify this value analysis confirms accounting measure ‘Accounting measures capture reality’

Financial Information Analysis8 Copyright 2006 John Wiley & Sons Ltd Market-based research Economic/Finance theory changes user perspective market determines reality constructionist? Accounting information: no intrinsic value how does it impact upon users? Testable by empirical studies

Financial Information Analysis9 Copyright 2006 John Wiley & Sons Ltd Portfolio Theory Finance theory Risk Quantifiable? Probability-related Past performance as basis? Use of mean with standard deviation Reduced through diversification Risk decreases as portfolio increases

Financial Information Analysis10 Copyright 2006 John Wiley & Sons Ltd Capital Asset Pricing Model Relationship between risk and return Assumptions investors are rational and risk-averse market is perfect with no transaction costs information has no cost and is free all can borrow and lend at risk-free rate Standard Deviation an appropriate measure of risk

Financial Information Analysis11 Copyright 2006 John Wiley & Sons Ltd CAPM Portfolio built incrementally  SD  ‘Relevant’ risk is impact of marginal investment on portfolio risk Unsystematic risk unique to security can be diversified away Systematic risk

Financial Information Analysis12 Copyright 2006 John Wiley & Sons Ltd Systematic (Market) Risk Cannot be diversified away How can it be measured? BETA (  ) index 2 bases risk-free (govt. bond):  = 0 market portfolio:  = 1 Past  taken as approximation of future 

Financial Information Analysis13 Copyright 2006 John Wiley & Sons Ltd CAPM Formula Portfolio Risk and Return known  formula

Financial Information Analysis14 Copyright 2006 John Wiley & Sons Ltd CAPM Useful model of expected returns Empirical tests confirm Major consequences for accounting is accounting information useful? information regarding future prospects irrelevant Fama and French

Financial Information Analysis15 Copyright 2006 John Wiley & Sons Ltd Arbitrage Pricing Theory (APT) Ross - APT Multi-index model macro-economic factors, interest rate, etc. ‘Additional risks incorporated into price to reflect increased risk’

Financial Information Analysis16 Copyright 2006 John Wiley & Sons Ltd Impact of Changes in Perspective CAPM, APT moved focus to market/user What is impact of accounting data on user? Is it worthwhile analysing accounting data? Is it worthwhile producing accounting data? What is role of accounting, if any? Is there a better arbiter of value/wealth?

Financial Information Analysis17 Copyright 2006 John Wiley & Sons Ltd Efficient Market Hypothesis (EMH) Focus on market/users Market as best captor of information Share price as best measure of wealth Sources of information other than accounting All impounded immediately in share price Stocks valued fairly in light of all available information

Financial Information Analysis18 Copyright 2006 John Wiley & Sons Ltd Efficiency ‘Share price reflects fairly and immediately all available information’ Efficiency? Allocative Operational Informational How does market react to information?

Financial Information Analysis19 Copyright 2006 John Wiley & Sons Ltd Weak-form ‘Past share movements no guide to future’ Information available: past share prices Empirical research supports Random walk No ‘normal’ value No advantage in analysing past share price EMH in weak-form widely accepted

Financial Information Analysis20 Copyright 2006 John Wiley & Sons Ltd Semi-strong form ‘Price reflects all publicly available data’ most Annual Report data probably already publicly available before issued i.e., ‘Price impounds information in Annual Report before issued’ If no advantage accrues, what is point of: Annual Report Analysis of AR Generally supported by empirical tests Anomalies

Financial Information Analysis21 Copyright 2006 John Wiley & Sons Ltd Strong form Price reflects all data (incl. insider info.) Testable by identifying market reaction to insider info. If all relevant info. impounded then there should be no effect In fact research indicates that there is a reaction Studies suggest that it is not sustainable

Financial Information Analysis22 Copyright 2006 John Wiley & Sons Ltd Positive Accounting Theory Accounting developed to mediate contracts Accounting has role as control mechanism Assumes no ‘correct’ approach Descriptive, not prescriptive Shapes reality as much as describes it Useful counter-balance to EMH Agency theory

Financial Information Analysis23 Copyright 2006 John Wiley & Sons Ltd Agency theory Natural ally of PAT People (managers) motivated by self-interest Control/Monitoring mechanism required Role for accounting: monitoring device provides language in which to phrase contract efficient medium through which to operate firm

Financial Information Analysis24 Copyright 2006 John Wiley & Sons Ltd Implications for FIA EMH fundamentally challenged claims of ‘usefulness’ of accounting information ‘Usefulness’ gradually re-asserted by: Un-sustainability of Strong form of EMH Insights from behavioural finance and economics Fundamental Analysis and market research Emphasises that accounting information must be: considered in broader contexts viewed as socially-constructed information understood within dynamics of financial markets

Financial Information Analysis25 Copyright 2006 John Wiley & Sons Ltd Summary Market approach challenges notions of: usefulness of accounting information efficacy of analysis of accounting data However, accounting has role as: measure of risk means of exploiting market anomalies source of info. for operational decision-making Research has re-established credibility of analysis as means of gaining advantage