Financial Accounting Theory

Craig Deegan

Chapter 10
Reactions of capital markets to financial
reporting
Slides written by Michaela Rankin

Copyright 2000 McGraw-Hill Book Co. Aust.

PPT t/a Financial Accounting Theory by Deegan

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Chapter 10: Capital markets reactions

Learning Objectives
In this chapter you will be introduced to
the role of capital market research in assessing
the information content of accounting
disclosures
the assumptions of market efficiency adopted
in capital market research

Copyright 2000 McGraw-Hill Book Co. Aust.

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Chapter 10: Capital markets reactions

Learning Objectives
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
Copyright 2000 McGraw-Hill Book Co. Aust.

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Chapter 10: Capital markets reactions

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
Copyright 2000 McGraw-Hill Book Co. Aust.

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Chapter 10: Capital markets reactions

Capital market versus

behavioural research
capital market research:
assesses the aggregate effect of financial
reporting on investors
considers only investors

Behavioural research:
analyses individual responses to financial
reporting
examines decision-making by many groups
eg. bank managers, loan officers, auditors

Copyright 2000 McGraw-Hill Book Co. Aust.

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Chapter 10: Capital markets reactions

Reasons for capital market

research
Information about earnings and its
components is the primary purpose of
financial reporting
earnings are oriented towards the interests of
shareholders
earnings is the number most analysed and
forecast by security analysts
reliable data on earnings is readily available
Copyright 2000 McGraw-Hill Book Co. Aust.

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Chapter 10: Capital markets reactions

Underlying assumption of
CMREMH
CMR relies on the assumption that equity
markets are efficient
in accordance with Efficient Market Hypothesis

efficient market defined as a market that

adjusts rapidly to fully impound
information into share prices when the
information is released
Copyright 2000 McGraw-Hill Book Co. Aust.

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Chapter 10: Capital markets reactions

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)
Copyright 2000 McGraw-Hill Book Co. Aust.

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Chapter 10: Capital markets reactions

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
Copyright 2000 McGraw-Hill Book Co. Aust.

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Chapter 10: Capital markets reactions

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 companys risk
dividends are a function of accounting
earnings
unexpected earnings rather than total earnings
expected to be associated with a change in
share price
Copyright 2000 McGraw-Hill Book Co. Aust. 10.10
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Chapter 10: Capital markets reactions

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

Copyright 2000 McGraw-Hill Book Co. Aust. 10.11

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Chapter 10: Capital markets reactions

Earnings/return relation
continued
Total or actual returns can be divided into:
normal (expected) returns given market-wide
movements
abnormal (unexpected) returns due to firmspecific share price movements

abnormal returns used as an indicator of

information content of announcements
Copyright 2000 McGraw-Hill Book Co. Aust. 10.12
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Chapter 10: Capital markets reactions

Results of CMRBall 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

Copyright 2000 McGraw-Hill Book Co. Aust. 10.13

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Chapter 10: Capital markets reactions

Results of CMRBall and

Brown (1968) studycontinued
Found:
information contained in the annual report,
prepared using historical cost was useful to
investors
85-90% of earnings announcement is
anticipated by investors
much of information is obtained from other
sources
Copyright 2000 McGraw-Hill Book Co. Aust. 10.14
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Chapter 10: Capital markets reactions

Results of CMRextent 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
Copyright 2000 McGraw-Hill Book Co. Aust. 10.15
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Chapter 10: Capital markets reactions

Results of CMRpermanent
and temporary changes
Research examined relation between the
magnitude of unexpected changes in earnings
(EPS) and magnitude of abnormal returns
known as the earnings response coefficient
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
Copyright 2000 McGraw-Hill Book Co. Aust. 10.16
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Chapter 10: Capital markets reactions

Results of CMRrelative
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
Copyright 2000 McGraw-Hill Book Co. Aust. 10.17
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Chapter 10: Capital markets reactions

Results of CMRinformation
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
Copyright 2000 McGraw-Hill Book Co. Aust. 10.18
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Chapter 10: Capital markets reactions

Results of CMRinformation
content of earnings forecasts
Announcements of expected earnings rather
than actual earnings are associated with
share returns
management and security analysts both
make forecasts

Copyright 2000 McGraw-Hill Book Co. Aust. 10.19

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Chapter 10: Capital markets reactions

Results of CMRbenefits 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
Copyright 2000 McGraw-Hill Book Co. Aust. 10.20
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Chapter 10: Capital markets reactions

Results of CMRrecognition
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

Copyright 2000 McGraw-Hill Book Co. Aust. 10.21

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Chapter 10: Capital markets reactions

Results of CMRsize
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
Copyright 2000 McGraw-Hill Book Co. Aust. 10.22
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Chapter 10: Capital markets reactions

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
Copyright 2000 McGraw-Hill Book Co. Aust. 10.23
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Chapter 10: Capital markets reactions

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
Copyright 2000 McGraw-Hill Book Co. Aust. 10.24
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Chapter 10: Capital markets reactions

Accounting earnings reflecting

informationcontinued
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
Copyright 2000 McGraw-Hill Book Co. Aust. 10.25
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Chapter 10: Capital markets reactions

Accounting earnings reflecting

informationcontinued
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

Copyright 2000 McGraw-Hill Book Co. Aust. 10.26

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Chapter 10: Capital markets reactions

Results of CMRAccounting
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)
Copyright 2000 McGraw-Hill Book Co. Aust. 10.27
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Chapter 10: Capital markets reactions

Results of CMREarnings
reflecting information cont.
Collins, Kothari and Rayburn (1987) found
evidence that share prices was a better
indicator of future earnings in larger firms
than smaller firms
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

Copyright 2000 McGraw-Hill Book Co. Aust. 10.28

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Chapter 10: Capital markets reactions

Results of CMREarnings
reflecting information cont.
Studies examining which asset value
approaches provide accounting figures that
best reflect market valuation found:
fair value estimates of banks financial instruments
seem to provide a better explanation of bank share
prices than historical cost (Barth, Beaver and
Landsman 1996)
revaluation of assets results in better alignment of
market and book values (Easton, Eddy and Harris
1993)
Copyright 2000 McGraw-Hill Book Co. Aust. 10.29
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