Lecture 5

ACCT 332 Accounting Thought and Practice

The Information Approach to Decision Usefulness
- Chapter
p 5
- FASB Concepts No. 5
- Ball and Brown (1968) An Empirical Evaluation of
Accounting Income Numbers

Objectives for Todays Class

What is the Information Approach to Decision
Usefulness?
Empirical Research on the Information Approach

Techniques

Information Reflected

I f
Information
ti C
Conveyed
d

ERCs

Extensions / Limitations

The Information Perspective

What is the role of Accounting and Financial

Reporting?

Financial Reporting is designed to provide

y
information that can be used in valuation analysis.
It does not have to be directly about value.
As unable to do so

It provides information that assists users in

predicting value.
The q
questions are then:

Does anybody actually use what we produce?

Are we meeting our objective of decisionusefulness?

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 volume
trading
l
around
d th
the release
l
off fifinancial
i l statements
t t
t

Hypothesis: price increases (decreases) after the release of

good (bad) news
news.

Information Perspective Research

) Beaver (1968),
(
) and others
- Ball and Brown ((1968),

The fundamental question addressed by this line of

research

Do investors use the accountants product?

The challenges to answering this simple

simple question

When do we look?
Short
Sh t Window
Wi d
/ Long
L
Window?
Wi d ?

1~3 days

Months~1y

What accounting measures should we examine?

How do we control for other events that affect stock
prices or trading?

Short window - easier to identify causality. However, there might be over or under-reaction in response to financial
statement releases. Historically, there has been under-reaction.
Long window - harder to identify causality. However, there is more time for the full reaction to the financial statement
releases to be observed.
Performance relative to market expectations. Focus here is on abnormal returns (difference between actual and
expected). This can be in EPS, Net income, stock returns etc.
Exclude the firms that had public releases like dividend announcements.

The Ball and Brown (1968) Study

The first study to statistically document a share price

response to reported net income
Basic methodology is still in use today

Better data available now

Good news for accountants what we produce

appears to be useful for decision makers (i
(i.e.
e has
information content)

Basic Methodology

Step 1: Did the firm release good news or bad news about
earnings

To assess whether the news was good or bad, we need a

g was expected
p
measure of what earnings

Only the unexpected component will cause a reaction

since expected earnings should already be incorporated
into price (Why?)

What did B&B do?

Looked at analyst forecasts and historical performance figures to guess at the

markets estimate

Nowadays most researchers use analysts estimates of

earnings to measure the market expectation

Available for most large firms (e.g. Yahoo Finance)

Constantly updated

However, there is systematic bias inherent in analyst estimates. Analysts are typically optimistic rather than
objective, as they want to encourage trade.

Basic Methodology (continued)

Step 2: What is the market reaction to earnings news?

Need to focus on firm-specific

firm specific price movement (i
(i.e.
e separate
out market wide news) Look at Alpha based on CAPM

Abnormal stock return during narrow window = actual return

expected return

Market reaction to the release of earnings

g news

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

Expected return = Rf + (Rm-Rf)

= (1-)Rf + (Rm)
Accordingly, (1-)Rf is the intercept, while
is the slope.

Step 3: Did price react positively (negatively) to good

((bad)) news?
4 main takeaways:
1. Investors do react to earnings
announcements; at the 0 mark,
both lines show a small but
observable reaction
2. Asymmetric response: Larger
reaction to bad news as
compared to good news. This
might be due to (i) risk aversion,
and (ii) managers having a
tendency to hide bad news.
3. Post-earnings announcement
drift: under-reaction in prices in
response to earnings
announcements
4. Accountants are in competition
with other sources of information;
a lot of the price movement has
already been incorporated into the
stock price prior to the earnings
announcement at 0.

0 is the earnings
announcement date

Causation v. Association

Short Window Studies

The Ball & Brown study demonstrates both causation and

association when analysed with short and long window studies.

Evidence
E
id
th
thatt fifinancial
i l statement
t t
t iinformation
f
ti causes
security price change

Narrow window studies are more consistent with the

decision usefulness of accounting information

Long Window Studies

Evidence that financial statement information is

associated with securityy p
price change
g

Short (Narrow) Window Studies: If a security market reaction to accounting information is observed during a narrow window of
a few days surrounding an earnings announcement, it can be argued that the accounting information is the cause of the
market reaction. This is as in a narrow window there are relatively fewer firm-specific events other than net income to affect
share returns. Also, if other events do occur such as stock splits or dividend announcements, the affected firms can be
removed from the sample. Thus, a narrow window relationship between security returns and accounting information suggests
that accounting disclosures are the source of new information to investors.
Long (Wide) Window Studies: Here, a host of other events during the examined period can and will affect share price. As the
market learns from more timely sources, share prices will move to reflect the new information. This reflects the partly
informative nature of security prices since, in an efficient market, security prices reflect all available information, not just
accounting information. Thus, because of recognition lag, prices lead earnings over a wide window. Thus the most that can be
argued for wide window studies is that net income and returns are associated.

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
balance
sheet
h t iinformation?
f
ti ? Y
Yes
Does the amount of abnormal share price change
correlate with amount of GN/BN? Yes

Earnings Response Coefficients (ERC)

Therefore the Ball&Brown article gives evidence to financial statements having an impact on security price changes that
1. Applies to quarterly earnings reports as well
2. Applies in other markets
3. Varies according to component information on financial statements
4. Varies according to the amount of GN/BN provided (ERC)

Research - Information Content

Extensions - ERC Studies

ERC: th
ERC
the magnitude
it d off the
th change
h
in
i stock
t k prices
i
for each unit of unexpected earnings

Analysis is on unexpected earnings, as the expected earnings should already have been factored into the stock price.

Following these early studies

studies, researchers turned to
assess the variation in market response:

Firm characteristics
Size, risk, leverage, growth, investor
Higher Size, Lower ERC
heterogeneity
g
y
Earnings Characteristics

Persistence quality
Persistence,

Higher Risk, Lower ERC

Higher Leverage, Lower ERC
Higher Growth, Higher ERC
Higher Investor Heterogeneity, Higher ERC

Earnings Quality: Magnitude of the main diagonal probabilities of

the associated information system
Earnings Persistence: The degree to which earnings will continue
into the future (recurring items)

Persistence

Earnings persistence: higher persistence

ERC

higher

If the value of the asset goes up by $1 today then

goes up
p by
y$
$1 and ERC is 1
the value of the firm g

If the value of the asset goes up by $1 today and is

expected to persist
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)

Persistence (continued)

Growth opportunities: higher opportunities, higher ERC

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 :

1 + 1 * (1 + 0.05) / (0.1 - 0.05) = 22

ERC can be negative. However, assume in questions that ERC is positive. This is important in analysing if markets are
efficient (e.g. in response to GN, prices should increase, and if BN, prices should decrease).

Implications of These Findings

Need to do a good job of distinguishing elements of different

persistence: separating
p
p
g transitory
y items from continuing
g items

A lot of one-time items get included in the income from

continuing operations
Separate disclosure of these items is haphazard

one time items

Management tends to draw attention to one-time
that are losses To stress that these will not recur, and that they are therefore
performing better on average than the information would suggest.

Need to do a better jjob of disclosing

gg
growth opportunities
pp
in
MD&A and segment disclosures

Group Questions

40 minutes to complete group questions

A i
Assignment
t off di
discussion-leading
i l di groups

The higher the proportion of institutional investors, the lower the in trading volume after earnings
announcements, as institutional investors have more sources of information and are more informed.
They thus do not rely as much on earnings announcements as retail investors to enter into buy/sell
decisions.
As the proportion of institutional investors initially increases, there is a corresponding increase in
trading volume due to the difference in opinions between institutional and retail investors. However,
up to a certain point, institutional investors will start forming the majority opinion in the market,
resulting in fewer trades.