acct 332 lecture 5 (noted)
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Lecture 5ACCT 332 – Accounting Thought and PracticeACCT 332 Accounting Thought and Practice
The Information Approach to Decision Usefulness
- Chapter 5p- FASB Concepts No. 5 - Ball and Brown (1968) An Empirical Evaluation of
Accounting Income NumbersAccounting Income Numbers
Objectives for Today’s Class
� What is the Information Approach to Decision Usefulness?Usefulness?
� Empirical Research on the Information Approach
Techniques• Techniques
• Information Reflected
I f ti C d• Information Conveyed
• ERCs
� Extensions / Limitations
The Information Perspective
• What is the role of Accounting and Financial Reporting?Reporting?
- Financial Reporting is designed to provide information that can be used in valuation analysis.y
• It does not have to be directly about value.
• It provides information that assists users inIt provides information that assists users in predicting value.
• The questions are then:q
- Does anybody actually use what we produce?
- Are we meeting our objective of decision-Are we meeting our objective of decision-usefulness?
Basic Approach to Evaluate Information Perspective
• An application of decision theory model
- Investors have prior probabilities of future firm performance
• Stock prices reflect that.
- Now if investors obtain useful information from financial statements,
• then investors should revise their probabilities when they process that information (Bayes’ theorem),
• this should then lead to buy/sell decisions, and
• we should then observe changes in security price and t di l d th l f fi i l t t ttrading volume around the release of financial statements
- Hypothesis: price increases (decreases) after the release of good (bad) newsgood (bad) news.
Information Perspective Research- Ball and Brown (1968), Beaver (1968), and others( ) ( )
• The fundamental question addressed by this line of researchresearch
- Do investors use the accountants㵭 product?
• The challenges to answering this “simple” question• The challenges to answering this simple question
- When do we look?
Sh t Wi d / L Wi d ?• Short Window / Long Window?
- What accounting measures should we examine?
- How do we control for other events that affect stock prices or trading?
The Ball and Brown (1968) Study
• The first study to statistically document a share price response to reported net incomeresponse to reported net income
• Basic methodology is still in use today
- Better data available now- Better data available now
• Good news for accountants – what we produce appears to be useful for decision makers (i e hasappears to be useful for decision makers (i.e. has information content)
Basic Methodology
• Step 1: Did the firm release good news or bad news about earningsearnings
- To assess whether the news was good or bad, we need a measure of what earnings was expectedg p
• Only the unexpected component will cause a reaction since expected earnings should already be incorporated into price (Why?)
- What did B&B do?
- Nowadays most researchers use analysts’ estimates of earnings to measure the market expectation
• Available for most large firms (e.g. Yahoo Finance)
• Constantly updated
Basic Methodology (continued)
• Step 2: What is the market reaction to earnings news?
- Need to focus on firm specific price movement (i e separate- Need to focus on firm-specific price movement (i.e. separate out market wide news)
• Abnormal stock return during narrow window = actual returnAbnormal stock return during narrow window actual return – expected return
- Market reaction to the release of earnings newsg
• Use narrow window – measure unexpected return at earnings date +/- 1 or 2 days
• Delete firms that had other announcements (e.g. dividend changes) at the same time
Separating Market-Wide and Firm-Specific Factors
Step 3: Did price react positively (negatively) to good (bad) news?( )
Causation v. Association
• Short Window Studies
E id th t fi i l t t t i f ti- Evidence that financial statement information causessecurity price change
- Narrow window studies are more consistent with the- Narrow window studies are more consistent with the decision usefulness of accounting information
• Long Window StudiesLong Window Studies
- Evidence that financial statement information is associated with security price changey p g
Research in the Years Following Ball & Brown (1968)( )
• With quarterly earnings reports? Yes
• On other stock markets? Yes
• Response to components on income statement and b l h t i f ti ? Ybalance sheet information? Yes
• Does the amount of abnormal share price change correlate with amount of GN/BN? Yescorrelate with amount of GN/BN? Yes
- Earnings Response Coefficients (ERC)
Research - Information Content
• Extensions - ERC Studies
ERC th it d f th h i t k i- ERC: the magnitude of the change in stock prices for each unit of unexpected earnings
- Following these early studies researchers turned to- Following these early studies, researchers turned to assess the variation in market response:
• Firm characteristicsFirm characteristics
• Size, risk, leverage, growth, investor heterogeneityg y
• Earnings Characteristics• Persistence qualityPersistence, quality
Persistence
• Earnings persistence: higher persistence o higher ERCERC
- If the value of the asset goes up by $1 today then the value of the firm goes up by $1 and ERC is 1g p y $
- If the value of the asset goes up by $1 today and is expected to go up by $1 each year forever, and the interest rate is 10%, then the value of the firm goes up by $1 + $1/.1 = $11 and the ERC is 11 (if accounting rules only allow recognition of $1)accounting rules only allow recognition of $1)
Persistence (continued)
• Growth opportunities: higher opportunities, higher ERC
Asset goes up by $1 today and then its value is expected to- Asset goes up by $1 today and then its value is expected to increase by 5% per year forever, and interest rate is still 10%, then the value of the firm will go up by :
Implications of These Findings
• Need to do a good job of distinguishing elements of different persistence: separating transitory items from continuing itemsp p g y g
- A lot of one-time items get included in the income from continuing operations
• Separate disclosure of these items is haphazard
• Management tends to draw attention to one-time itemsManagement tends to draw attention to one time items that are losses
• Need to do a better job of disclosing growth opportunities in j g g ppMD&A and segment disclosures
Group Questions
• 40 minutes to complete group questions
• A i t f di i l di• Assignment of discussion-leading groups