Business

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Accounting Theory

MD. SAIFUL ALAM, LECTURER

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08/28/11

Session Topic

Reactions of Capital Markets to Financial Accounting

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Key Objectives

Understand the role of capital market research in assessing the information content of accounting disclosures.

Understand 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.

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The features of and Rationale for the Capital Market Research

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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 (financial and non-financial information)

No share price change implies no reaction

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Features of Capital Market Research

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“A large fraction of published research in leading academic accounting journals examines the relation between financial statement information and capital market, referred to as capital market research”- S. P. Kothari (2001)

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Views

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Capital Market Vs. 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)

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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

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Underlying Assumptions of Capital Market Research - EMH

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Assumptions

CMR relies on the assumption that equity markets are efficient

– in accordance with Efficient Market Hypothesis (EMH)

Efficient market defined as a market that adjusts rapidly to fully impound information into share prices when the information is released

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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)

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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

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Information Content of Earnings

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The information content of Earnings

Share prices are the sum of expected future cash flows from dividends

Dividends are a function of accounting earnings

Unexpected earnings rather than total earnings expected to be associated with a change in share price

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The information content of earnings —market model

Used to separate out firm-specific share price movements from market-wide movements

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

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Information content of earnings — continued

Total or actual returns can be divided into:

– normal (expected) returns given market-wide movements

– abnormal (unexpected) returns due to firm-specific share price movements

Abnormal returns used as an indicator of information content of announcements

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Results of Capital Market Research

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Research Question?whether firms with unexpected increases in accounting earnings had positive abnormal returns, and firms with unexpected decreases had negative abnormal returns

Sample SizeExamined data from 261 US firms

Seminal Paper (Ball and Brown, 1968)

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Ball and Brown (1968)-Findings

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

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Other Results of CMR Extent of alternative sources of information

Permanent versus temporary changes

Information announcement of other firms

Information content of earnings forecasts

Benefits of voluntary disclosure

Recognition versus footnote disclosures

Size

Accounting earnings and future information

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Results of CMR—extent 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 (Brown, 1970)

– less alternative sources of information for Australian market

– Less alternative sources of information for smaller firms than larger firms

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Results of CMR—permanent and temporary changes

Research (Beaver et al., 1980) 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

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Results of CMR—information 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

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Results of CMR—information content of earnings forecasts

Announcements of expected earnings rather than actual earnings are associated with share returns

Management and security analysts both make forecasts

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Results of CMR—benefits 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

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Results of CMR—recognition 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

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Results of CMR—size

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

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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

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Accounting Earnings Reflecting Information

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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

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Accounting earnings reflecting information—continued

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

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Accounting earnings reflecting information—continued

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

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Results of CMR—Accounting earnings reflecting information

Share prices and related returns were related to accounting earnings (Beaver, Lambert and Morse (1980))

– because of various information sources, price appeared to anticipate future accounting earnings

– supported by Beaver, Lambert and Ryan (1987)

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Results of CMR—Earnings 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

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Results of CMR—Earnings reflecting information cont.

Studies examining which asset value approaches provide accounting figures that best reflect market valuation found:

– fair value estimates of bank’s 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)

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Relaxing Assumptions about Market Efficiency

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Questionable Efficiency?

In recent years, there has been some research which has questioned assumptions of market efficiency (see Kothari 2001). Share prices are found to take time to react

to particular information-such as corporate earnings announcement-referred to as 'drift'

Leads to opportunities for some capital market participants to make gains in periods when share prices do not fully reflect the available information

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Questionable Efficiency?

In light of market failures surrounding the sub-prime banking crisis, the credit crunch and the global financial crisis that came to light from 2007 onwards, several commentators have argued that some of the fundamental assumptions underlying much modern economic theory (including the efficiency of markets) have been shown to be unrealistic in practice (McSweeny, 2009)

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Questionable Efficiency?

At the present time, there is some research into capital markets that does not rely upon market efficiencies. The consideration of 'other forces' that shape share prices and returns might eventually lead to a revolution in thought-but it will arguably take a long time. (Kuhn-1962- view of religious conversion--- Attacking existing theory----Proving new one superior----knowledge develops----New paradigm replaces or resurrects prior paradigm----Religious conversion).

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Thank you!

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