1. 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

2. 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

3. 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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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. 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

11. 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

12. 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

13. 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

14. 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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

15. 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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

16. 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

17. 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

18. 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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

19. 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

20. 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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

21. 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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

22. 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

23. 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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24. 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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

25. 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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26. 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)
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

27. 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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

28. 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)
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

29. 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 ‘under-react’ 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?
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan