Chapter 8:

Usefulness of Accounting Information

to Investors and Creditors
Firm valuation models Company-auditor
Efficient-markets roles
hypothesis Accounting data and
CAPM creditors
Cross-sectional Accounting
valuation studies allocations
Information
economics
Financial Accounting Standards Board

Primary user groups

Investors
Creditors
Cost-Benefit calculus
Cost considerations confined to producers
Benefits for investors and creditors
Firm Valuation Models
Dividend valuation model: value of a firm is the
present value of future expected dividends to be
received by stockholders
Cash flow valuation model: value of firm is the
present value of future net cash flows
Theoretical literature implications are that accrual
accounting systems incorporate the attribute that
determines firm valuation...net cash flow data.
Efficient-Markets Hypothesis (EMH)
Information content:
when an item of
information causes a
price response in the
security
Three forms
Weak
Semistrong
Strong
Incomplete Revelation Hypothesis
Difficult to extract
disclosure
some accounting numbers
or relationships are more
difficult or costly to
uncover and their effects
may not be fully revealed in
security prices
This is contrary to the EMH
assumption
Noise traders
individuals who do not
necessarily respond in a
completely rational way in
terms of responding to new
information in terms of
their trading habits
may be rebalancing their
portfolios, responding to
liquidity shocks or even
acting upon whims
Foundation of Capital Market Research
Portfolio Theory
Risk can be reduced
by holding a portfolio
of investments
Risk types
Unsystematic
(diversifiable)
Systematic
(undiversifiable)
Capital Asset pricing Model (CAPM)
Theoretical pricing of stocks
Market assumed to be a diversified portfolio
Correlation made between returns on
individual stocks and market returns
Regression analysis fits a line to the
scattergraph
Slope of the characteristic line is beta
Security Returns vs. Market Returns
+ Return on Stock

Return on Market

Characteristic Line

-
 Rj = i + Bj (Rm – i)
Rj = expected return on security j
i = risk-free rate of return
Rm = expected return on the market portfolio

Bj = beta coefficient for security j

Empirical studies in accounting use a
simpler approach called the market model

Rj = j + Bj (Rm) + ej

j = the intercept from the regression

ej = random error term

Unexpected or Abnormal Returns
Captured in the error term ej
A common research approach is to regress
these abnormal returns on accounting
variables such as unexpected reported
earnings for the same time period to
determine if there is information content
Ball and Brown (1968)
Information content of accounting numbers
Seminal study showed the direction of
change in reported earnings was positively
correlated with security price movements
Not surprising...expect accounting income
to be part of the information used by
investors in assessing risk and return
Capital Market Research
Accounting earnings appear to have information
content and to affect security prices
Alternative accounting policies with no apparent
cash flow consequences have no information
content
Alternative accounting policies with cash flow
consequences do have information content
Capital Market Research
Incentives exist to choose certain
accounting policies where choice exists,
owing to indirect cash consequences
Accounting-based risk measures correlate
with market risk measures, suggesting that
accounting numbers are useful for risk
assessment
Another research approach
Examine the association between
accounting data reported in the financial
statements and the levels of stock prices
(not the abnormal returns)
Referred to as cross-sectional valuation
Company-Auditor Roles
Key assumption of accounting research is
that financial statement information is
reliable...GAAP applied on consistent basis
Jointly produced by company and auditor
Demand can be explained by agency theory
Auditor research
Qualified audit report leads to lower stock price
Big Six audits more highly valued
Accounting Data and Creditors

Predicting corporate bankruptcy (loan

default)
Bond ratings
Interest-rate risk premiums on debt
Experimental studies of the role of
accounting data in lending decisions
Usefulness of Accounting Allocations
Revenue recognition and the matching of costs to
revenues over multiple accounting periods
requires use of allocations
Criticized as arbitrary, no allocation is completely
defensible against other methods
No evidence to support the contention that
allocation-based financial statements are useless
Accounting Information Evaluation
Information economics, decision theory
Does not provide answers to normative
questions
Can determine only the value of specific
information for a narrowly defined decision
Limitations
Real world decision makers face more complex
decisions
User diversity is an issue; behaviors may vary
Chapter 8:
Usefulness of Accounting Information
to Investors and Creditors
Firm valuation models Company-auditor
Efficient-markets roles
hypothesis Accounting data and
CAPM creditors
Cross-sectional Accounting
valuation studies allocations
Information
economics