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