Chapter 5: The Information Chapter 5: The Information Approach to Decision UsefulnessApproach to Decision Usefulness

• Ari BenarrochAri Benarroch

• Nazish HaqNazish Haq

• Qin LinQin Lin

• Nikhil SequeiraNikhil Sequeira

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

OverviewAccounting 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 In essence information is useful if it changes investor beliefs beliefs

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

Definition

What does this mean?

Investors want to make their own predictionsInvestors want to make their own predictions

Research can help accountants determine what Research can help accountants determine what information is usefulinformation is useful

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?What was the effect on RIM share price that day?

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.

Finding Market Response

Efficient market theory implies that the market will react Efficient market theory implies that the market will react quickly to new informationquickly to new information

Good or bad news is evaluated relative to what investors Good or bad news is evaluated relative to what investors expectedexpected

There are multiple events that affect a firms share price, There are multiple events that affect a firms share price, so finding the effect of net income can be hardso finding the effect of net income can be hard

Separating Market Wide and Firm Specific factors

Comparing Returns and Income

If income announcement is good news then we If income announcement is good news then we have a positive abnormal share returnhave a positive abnormal share return

Vice versa for bad news income announcementVice versa for bad news income announcement

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.

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

Figure 5.3 Abnormal Returns for GN and BN Firms

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

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.

Research Paper“ The Effect of CEO ownership on the information content of Reported Earnings” ” By: Aloke Ghosh, Doocheol Moon.By: Aloke Ghosh, Doocheol Moon.

This paper examines the relation between capital market This paper examines the relation between capital market perceptions of earnings quality and CEO Equity ownership.perceptions of earnings quality and CEO Equity ownership.

The research concludes that the earnings response coefficients The research concludes that the earnings response coefficients (ERCs) decline across higher levels of CEO ownership with an (ERCs) decline across higher levels of CEO ownership with an inflection point around 25% ownership.inflection point around 25% ownership.

The result suggests that, for low levels of CEO ownership, The result suggests that, for low levels of CEO ownership, earnings are more informative about future firm performance earnings are more informative about future firm performance

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

Efficient Response Coefficient (ERC)

Why do movie go-ers respond to changes in Why do movie go-ers respond to changes in movie opening dates?movie opening dates?

Study by: Linar Einav and Abraham RavidStudy by: Linar Einav and Abraham Ravid

Efficient Response Coefficient (ERC)

Measures the extent of a securities abnormal Measures the extent of a securities abnormal market return in response to the unexpected market return in response to the unexpected component of reported earnings of the firm component of reported earnings of the firm issuing that security issuing that security

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

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

Reasons for Differential Market Response

1) Permanent: expected to last indefinitely

2) Transitory: affecting earrings in the current year only

3) Price Irrelevant: zero persistency

3 Types of Earning Events

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

Reasons for Differential Market Response

Informativeness of Price: the more informative the price, the less informative the content of current accounting earnings = lower ERC

Reasons for Differential Market Response

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

Classificatory Smoothing

Definition: Management would choose to Management would choose to classify unusual items above or below the classify unusual items above or below the operating earnings line; a.k.a smoothing out operating earnings line; a.k.a smoothing out earnings.earnings.

Characteristic 3 (from previous slide) was put Characteristic 3 (from previous slide) was put into place for this reason in 1989into place for this reason in 1989

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.

Theory in Practice

Have we improved financial reporting with Section 3480 Have we improved financial reporting with Section 3480 in place?in place?

Many companies were incurring substantial expenses and Many companies were incurring substantial expenses and revenue losses due to the September 11th terrorist attacks. revenue losses due to the September 11th terrorist attacks.

Ex: Airlines were unable to fly for two daysEx: Airlines were unable to fly for two days

FASB did not allow attacks to be considered extraordinary FASB did not allow attacks to be considered extraordinary because it was too hard to differentiate between direct because it was too hard to differentiate between direct costs (loss of revenue for the 2 day shut down period) and costs (loss of revenue for the 2 day shut down period) and indirect costs ( consumer fear of flying for safety reasons).indirect costs ( consumer fear of flying for safety reasons).

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.

THE ENDTHE END

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