Chapter 8: Usefulness of Accounting Information to Investors and Creditors Firm valuation models Efficient-markets hypothesis CAPM Cross-sectional valuation studies Company-auditor roles Accounting data and creditors Accounting allocations Information economics

Financial Accounting Standards Board Primary user groups Investors Creditors Cost-Benefit calculus Cost considerations confined to producers Benefits for investors and creditors

Firm Valuation Models Dividend valuation model: value of a firm is the present value of future expected dividends to be received by stockholders Cash flow valuation model: value of firm is the present value of future net cash flows Theoretical literature implications are that accrual accounting systems incorporate the attribute that determines firm valuation...net cash flow data.

Efficient-Markets Hypothesis (EMH) Information content: when an item of information causes a price response in the security Three forms Weak Semistrong Strong

Incomplete Revelation Hypothesis Difficult to extract disclosure some accounting numbers or relationships are more difficult or costly to uncover and their effects may not be fully revealed in security prices This is contrary to the EMH assumption Noise traders individuals who do not necessarily respond in a completely rational way in terms of responding to new information in terms of their trading habits may be rebalancing their portfolios, responding to liquidity shocks or even acting upon whims

Foundation of Capital Market Research Portfolio Theory Risk can be reduced by holding a portfolio of investments Risk types Unsystematic (diversifiable) Systematic (undiversifiable)

Capital Asset pricing Model (CAPM) Theoretical pricing of stocks Market assumed to be a diversified portfolio Correlation made between returns on individual stocks and market returns Regression analysis fits a line to the scattergraph Slope of the characteristic line is beta

Security Returns vs. Market Returns Return on Stock Return on Market Characteristic Line + -

RjRj = expected return on security j i= risk-free rate of return RmRm = expected return on the market portfolio BjBj = beta coefficient for security j R j = i + B j (R m – i)

Empirical studies in accounting use a simpler approach called the market model R j =  j + B j (R m ) + e j jj = the intercept from the regression ejej = random error term

Unexpected or Abnormal Returns Captured in the error term e j A common research approach is to regress these abnormal returns on accounting variables such as unexpected reported earnings for the same time period to determine if there is information content

Ball and Brown (1968) Information content of accounting numbers Seminal study showed the direction of change in reported earnings was positively correlated with security price movements Not surprising...expect accounting income to be part of the information used by investors in assessing risk and return

Capital Market Research Accounting earnings appear to have information content and to affect security prices Alternative accounting policies with no apparent cash flow consequences have no information content Alternative accounting policies with cash flow consequences do have information content

Capital Market Research Incentives exist to choose certain accounting policies where choice exists, owing to indirect cash consequences Accounting-based risk measures correlate with market risk measures, suggesting that accounting numbers are useful for risk assessment

Another research approach Examine the association between accounting data reported in the financial statements and the levels of stock prices (not the abnormal returns) Referred to as cross-sectional valuation

Company-Auditor Roles Key assumption of accounting research is that financial statement information is reliable...GAAP applied on consistent basis Jointly produced by company and auditor Demand can be explained by agency theory Auditor research Qualified audit report leads to lower stock price Big Six audits more highly valued

Accounting Data and Creditors Predicting corporate bankruptcy (loan default) Bond ratings Interest-rate risk premiums on debt Experimental studies of the role of accounting data in lending decisions

Usefulness of Accounting Allocations Revenue recognition and the matching of costs to revenues over multiple accounting periods requires use of allocations Criticized as arbitrary, no allocation is completely defensible against other methods No evidence to support the contention that allocation-based financial statements are useless

Accounting Information Evaluation Information economics, decision theory Does not provide answers to normative questions Can determine only the value of specific information for a narrowly defined decision Limitations Real world decision makers face more complex decisions User diversity is an issue; behaviors may vary

Chapter 8: Usefulness of Accounting Information to Investors and Creditors Firm valuation models Efficient-markets hypothesis CAPM Cross-sectional valuation studies Company-auditor roles Accounting data and creditors Accounting allocations Information economics