1. 10-1 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Financial Accounting Theory Craig Deegan Chapter 10 Reactions of capital markets to financial reporting Slides written by Craig Deegan

2. 10-2 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 –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

3. 10-3 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

4. 10-4 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Capital market versus behavioural research Capital market research (the topic of this lecture) –assesses the aggregate effect of financial reporting on investors –considers only investors Behavioural research (the topic of the next lecture) –analyses individual responses to financial reporting –examines decision-making by many groups  e.g. bank managers, loan officers, auditors

5. 10-5 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Reasons for capital market research Information about earnings and its components is the primary purpose of financial reporting Earnings are oriented toward the interests of shareholders Earnings is the number most analysed and forecast by security analysts Reliable data on earnings is readily available

6. 10-6 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

7. 10-7 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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)

8. 10-8 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

9. 10-9 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Market efficiency – share prices react to information from various sources For example, material provided within the textbook indicates that share prices have been found to react not only to earnings data but also to such things as: –News about senior executive resignations –Takeover rumours posted to internet discussion sites  Which raises possible issues about the regulation of information provided on such sites –Concerns raised by auditors, particularly in relation to going concern considerations (unless anticipated by the market) –Industry-wide changes, such as the implications associated with the introduction of particular legislations (such as the Sarbanes-Oxley Act in the US)

10. 10-10 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Share prices react to information from various sources (cont.) Again, a share price reaction indicates that the ‘news’ has ‘information content’ Conversely, no share price reaction indicates that the news or event did not act to cause the market to revise any previous expectations held about a firm’s future cash flows

11. 10-11 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

12. 10-12 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

13. 10-13 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

14. 10-14 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

15. 10-15 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

16. 10-16 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 –Some research has shown that 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

17. 10-17 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

18. 10-18 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 For example, if an organisation within an industry is the first to prepare its financial results for the year, and it reports record profits that were unexpected by the market, then this would often cause share price increases across the industry –For example, Accounting Headline 10.6 shows that when CBA reported record profits this was followed by share price increases in other banks even prior to their earnings announcements

19. 10-19 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

20. 10-20 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

21. 10-21 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

22. 10-22 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

23. 10-23 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Results of CMR—unexpected changes in earnings vs. unexpected changes in expenses If ‘earnings surprises’ are accompanied by revenue surprises of similar magnitude in the same direction, then the earnings surprises are driven by revenue growth rather than by a reduction in expenses. Researchers expect earnings growth driven by revenue growth to exhibit a different level of persistence compared with earnings growth driven by expense reduction. Jegadeesh and Livnat's (2006) results indicate that the market does tend to react more to unexpected earnings when these 'surprises' are due to increases in revenues.

24. 10-24 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

25. 10-25 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

26. 10-26 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

27. 10-27 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

28. 10-28 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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)

29. 10-29 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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

30. 10-30 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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)

31. 10-31 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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?