Chapter 5: The Information Approach to Decision Making

Overview

• This chapter answers the question:• Do security market prices respond to

accounting information?

• A number of studies were completed to answer this question • Ball and Brown study from 1968

Overview Cont’d• The information approach is the equating of usefulness to information content

• Investors want to make their own predictions rather than have accountants do it for them

• Information is useful if it leads investors to change their beliefs and actions

• The degree of usefulness can be measured by the extent of volume or price change following the release of information

Does Disclosure Matter• Does releasing lots of information help stakeholders make more informed decisions and help to better gage the value of the firm? Or is it viewed as unreliable since management is producing the data?

• Are there dangers of disclosure?

Decision Making

• Deals with regulation standards on environmental disclosure

• Most owners use information about environmental disclosures to make decisions

• The media plays a critical role to convey non-financial information

Amount of Disclosure

• Convergence within industries to disclose certain trends

• Canada faces less impact than other countries such as Germany and France

• What is the ideal level of disclosure?

Reasons for Market Response

Consider the following predictions about investor behaviour in response to financial statement information:

1. Investors have prior beliefs about a firm’s future performance

2. When the current period’s net income is released, some investors will decide to become more informed by analyzing the income number

3. Investors who have revised their beliefs about future firm performance upwards, will buy the firm’s shares at their current market price

4. Expect to observe the volume of shares traded to increase when the firm reports its net income

Reasons for Market Response Cont’d

• A study was completed by Beaver, Clarke and Wright which examined trading volume reaction

• Found a dramatic increase in trading volume during the week that earnings announcements were released

Reasons for Market Response Cont’d

Finding the Market Response1. Efficient markets theory implies that the

market will react quickly to new information

2. The good or bad news in reported net income is evaluated relative to what investors expected

3. There are always many events taking place that affect a firm’s share volume and price

Equation of the market model:

• Rjt= αj + βJRMt+εjt

• Rjt = Return on firm j’s shares for period t

• RMt = Return on market portfolio for period t

• εjt = firm specific return on j’s shares

Separating Market-Wide and Firm-Specific Factors

• Ror this equation researchers obtain past data on Rjt and RMt

• Then use regression analysis to estimate the coefficients of the model• For example suppose:

• αj = 0.0001

• βJ = 0.80

Separating Market-Wide and Firm-Specific Factors Cont’d

• The researcher must now consult the financial media to identify the day of the firm’s current earnings announcement• Call this day “0”• Suppose for this day the return on the Dow

Jones Industrial Index was 0.001

Separating Market-Wide and Firm-Specific Factors Cont’d

• Next the estimated market model for firm j is used to predict the return on firm j’s shares for that day

• Expected return = 0.0001 + (0.80 x 0.001)

= 0.0009

Separating Market-Wide and Firm-Specific Factors Cont’d

• Assume the actual return on firm j’s shares for day 0 is 0.0015

• The difference between actual and expected is 0.0006 (εjt )

• This number is an estimate of the abnormal, or firm-specific, return on firm j’s shares for that day

Separating Market-Wide and Firm-Specific Factors Cont’d

Separating Market-Wide and Firm-Specific Factors Cont’d

• Graphical illustration of the market model for firm j for period t

Comparing Returns and Income• We can now compare the abnormal share

return on day 0 as calculated above with the unexpected component of the firm’s current reported net income

• If this unexpected net income is good news, then given securities market efficiency, a positive abnormal share return gives evidence that investors, on average, are reacting favourably to the unexpected good news in earnings

Difficulties with the methodology:1. Other firm-specific information is frequently

released around the time as a firm’s earnings announcement

2. The firm’s beta is an estimation

Comparing Returns and Income Cont’d

Ball and Brown Study Cont.

• Ball and Brown conducted the study in 1968

• The study was conducted on a sample of 261 NYSE firms in attempt to determine market price response to earnings information

Ball and Brown Study

• http://www.youtube.com/watch?v=_QDBX9KfxHM&feature=relmfu

B&B - Methodology

• They determined abnormal return over expected return and compared it to good income performance (GN) or bad income performance (BN) via a performance proxy i.e. last year’s earnings compared to this year’s earnings

• Observed results over a narrow window of one month and a wide window of 18 months

B&B - Results• Both narrow and wide windows related good news to positive returns and bad news to negative returns

• Noticed that when using the wide window, the price of shares with positive income news were already increasing prior to GN release

• Study suggests that 85-90% of information was already built into price by the time earnings were announced

B&B - Results

B&B - Outcomes

• Since both wide and narrow windows related good news with positive price changes and vice versa with bad news we can conclude that income news is only correlated with price change, it does not cause the change

• Beaver, Clarke and Wright in 1979 extended the study to examine the effects of the magnitude of unexpected earnings and concluded that greater unexpected earnings were correlated with greater market response

Earnings Response Coefficients •From the BB study we can see that on average good news (“GN”) firms enjoyed abnormal returns and that bad news (“BN”) firms showed negative returns

•Why does the market respond more strongly to good or bad news in earnings reports for some firms than for others?

• With the answer to this, accountants can improve their understanding of how information is useful to investors and in turn prepare more useful financial statements

Earnings Response Coefficients Cont’d

•Earnings Response Coefficient – measures the extent of a security’s abnormal market return in response to the unexpected component of reported earnings of the firm issuing that security

• ERC = Abnormal Share Return / Unexpected Earnings for Period

• Measures abnormal return per dollar of abnormal earnings

Reasons for Differential Market Response

1. Beta2.Capital Structure3.Earnings Quality4.Growth Opportunities5.The Similarity of Investor Expectations6.The Informativeness of Price

Beta• Recall: Beta measures the co-movement

between changes in the price of a security and changes in the market value of the market portfolio

• The riskier future returns are the lower investors’ reactions to a given amount of unexpected earnings will be

• Higher beta securities generally have lower ERC’s

Capital Structure

• Increases in earnings add strength and safety to bonds and other outstanding debt so much of the GN in earnings goes to the debt holders

• Highly levered firms generally have lower ERC’s

Earnings Quality• Recall: Quality of earnings is defined by the magnitude

of the diagonal probabilities of the associated information system

• Thus the higher the probabilities are the higher the ERC will be because investors are better able to infer future firm performance from today's performance

• Problem: information system probabilities are not directly observable

• Solution: Infer earnings quality by the magnitude of analysts' earnings forecast revision announcement

Earnings Quality Cont’d

• Why do analysts adjust estimates more for some firms than others?

• Earnings persistance• Permanent, expected to persist indefinately• Transitory, affecting earnings in current year but not

future years• Price irrelevant, persistence of zero

• In effect there are three ERC's each of which could be present in the same income statement

• Investors should attempt to identify the different types separately and assign different ERC's to each rather than trying to estimate an average

Earnings Persistence Example

Assess the earnings persistence for the following events (Permanent, Transitory or Price irrelevant):

1. Unanticipated gain from disposal of equipment

2. A new technology is developed which is expected to increase profits by 5% in perpetuity

3. The firm capitalizes a lot of organization costs

Earnings Persistence Example

Assess the earnings persistence for the following events (Permanent, Transitory or Price irrelevant):

1. Unanticipated gain from disposal of equipment - Transitory

2. A new technology is developed which is expected to increase profits by 5% in perpetuity - Permanent

3. The firm capitalizes a lot of organization costs - Price irrelevant - assuming organizational costs have no salvage value

Earnings Quality Cont’d

• Second dimension of earnings quality is accruals quality• Net Income = Cash Flow from Operations +/- Net Accruals

• Accruals include changes in non-cash working capital accounts (AR, AFDA, AP, inventories etc.)

• High quality - accruals show up as cash flow the next period

• Ex. If AR is $1,000 and AFDA is $100 and $900 is collected the next period, the accruals are considered high quality

• DeChow and Dichev

Δ WCt = b0 + b1 CFOt-1 + b2 CFOt + b3 CFOt+1 + Et

Δ WC = change in net non-cash working capitalt = periodCFO = cash flow from operations in period tb = constants that are to be estimatedE = residual error term (portion of total accruals not explained by cash from operations)

Testing Accrual Quality

Testing Accrual Quality Cont’d

Δ WCt = b0 + b1 CFOt-1 + b2 CFOt + b3 CFOt+1 + Et

• Data is used from several periods• High E indicates a poor match between current accruals and subsequent actual operating cash flow realizations

• ERC and share price respond positively to accrual quality

Growth Opportunities•GN or BN may suggest future growth opportunities and hence a higher ERC• Ex. Recent projects display unexpected high profitability

•To assess growth often P/E shops and portfolio managers analyze the ratio of market value of equity / book value of equity

• The market will be aware of growth opportunities before they are recognized in income thus driving the stock price up

Growth Opportunities Cont’dTo better understand analyze a simple perpetuity:

• Calculate the present value of a 10 % perpetuity:1/10% = $10

• Now assume the same perpetuity will grow by 5% per year: 1/(10%-5%) = $20

Clearly the value increases when growth opportunities are introduced

Similarities of Investor Expectation

•Each investor will have a different expectations based on the amount of available information to them and their abilities to comprehend it

•However these differences are reduced since many investors draw their information from similar sources – analyst consensus forecasts etc.

•Depending on expectations they will interpret earnings news as GN or BN but since most expectations are similar they will generally have the same interpretation of the news

• The more similar the expectations are the greater the effect will be on the ERC

The Informativeness of Price

•Market price itself is partially informative about the future value of the firm (leads)

• Market price includes all publicly known information about the firm

• A more informative share price implies the market anticipates changes in earnings power sooner

•The more informative the price the less informative earnings releases will be and hence the firm will have a lower ERC

Reasons for Differential Market Response

• An increase in the following factors will lead to:

  Effect on ERCBeta Lower Capital Structure LowerEarnings Quality HigherGrowth Opportunities HigherSimilarity of Investor Expectation HigherThe Informativeness of Price Lower

Questions

Assess the impact on the firm’s ERC:

1. A firm’s beta increases from 1 to 2.3

2. A firm pays off 20% of their debt

3. The firms quality of earnings falls

4. The return on recent projects that the firm has been taking on have been experiencing lower than historical projects

Questions Cont’d

Assess the impact on the firm’s ERC:

5. Investors expectations become more similar

6. Due to improved news coverage the price becomes more informed

Implications of ERC Research•Improved understanding of market responses allows accountants to create and provide more useful information to investors

• Capital structure – highly levered firms should have lots of detail disclosing the nature and extent of all liabilities

• Growth – the MD&A enables management to communicate growth prospects

• Components of net income are important because they allows investors to better interpret the earnings number

Implications of ERC Research Cont’d

•IAS 1 prohibits the use of extraordinary items in the income statement and requires separate disclosure in the notes for:

• Material write-downs and reversals thereof• Restructuring provisions• Gains and losses on provisions• Other low-persistent items

•This puts considerable onus on the accountant to fully disclose details of unusual, non-recurring and extraordinary items

Measuring Investors’ Earnings Expectations

•Must obtain a reasonable proxy for expected earnings because the market will only react to the component of net income they did not expect

•When conditions are not ideal earnings expectations are more complex

•Ways to deal with this complexity:• Time Series approach• Analysts’ forecasts

Time Series Approach

•Analyze the persistence of past earnings to forecast future earnings

•The two extremes of earnings persistence:• Completely persistent – expected earnings for

current year are last year’s actual earnings and estimated as the change from last year

• Zero persistence – no information from last year is used and all earnings this year are unexpected

Analyst forecasts

•More accurate than time series forecasts• Analysts interpret more information than past

earnings•The age of a forecast has an important fact on its accuracy

•The most recent earnings forecast provided a more accurate earnings production than the average forecast of all analysts following the firm (ignoring how old the individual forecasts were)

• Timeliness dominates the cancelling-out-of-errors effect of the average forecast

Summary

•The market is on average very sophisticated in its ability to evaluate accounting information

• This supports the theory of securities market efficiency and supports the decision usefulness approach to financial reporting

•As accountants better understand investor response they will be able to provide more useful information to investors

The “Best” Accounting Policy

• Need to be careful to not only consider the market

• Accounting information is a public good• Accounting information should benefit

society overall

Other Financial Statement Information

• Some supplementary information impacts the market before annual reports are released

• It can often be difficult to determine when some information is found out by the market, this makes finding its impact more difficult

• Other financial statement and supplementary information augments the market reaction to earnings information

Bio-tech Article

• Expanding biotech industry is generating large revenues in both Canada and USA

• Purpose is to test, develop and produce drugs

• Large part of firms capital is raised through public investment and is determined by firms disclosure plan

Disclosure and Value• Non-financial statements are key to helping outside investors determine firm value and decide where to invest

• Management can selectively disclose information through various public releases

Bio-tech Process• Capital needed through stages of development and testing

• Pre clinical > Investigational New Drug Stage  > Phase I clinical trial > Phase II clinical trial >Phase III clinical trial > FDA Final Approval

• Start with animals and move to humans need approval at most stages to continue testing and development

Investors• Financial investors need to find present value of cash flows but drug testing is a long process with a lot of uncertainty

• Non-financial statements become increasingly important

•  Market value based on beliefs• The study shows that investors reacted more to non-financial information than earnings information

Non Financial Disclosure• Demonstrates that non-financial information drives value more than earnings information

• Report to shareholders• Press releases• Web site disclosures• Regulatory filings

• Lag of stock price and accounting system

Conclusion

• Investors attempt to predict future events using all forms of information

• Accountants must consider market response in the preparation of accounting information to stay competitive

• Research is done to determine the markets response to information

• The more information accountants provide the better the flow of resources in capital markets

Conclusion Cont’d

• Cannot only consider market reaction• The market’s reactions are very

sophisticated• Research supports the efficient markets

theory and decision theories• Must make sure to disclose unusual and

nonrecurring events

Conclusion Cont’d

• Investors are more reactive to non-financial information than earnings information, but still augments earnings response

• The information approach has led lots of research that has enhanced the decision usefulness of accounting