2/1/2021

AF5102
Accounting Theory

Lecture 4-5
The Value Relevance of Accounting Information

Dr. Zhang Yong

Email: yong.zhang@polyu.edu.hk
Office: M1042

“Baidu Net More Than Doubles”

The Wall Street Journal, February 1, 2011

Daily Return of Baidu, Inc. (BIDU)

10.00%

8.00%

Announcement of
6.00% 2010 Q4 earnings

4.00%

2.00%

0.00%
1/3 1/5 1/7 1/9 1/11 1/13 1/15 1/17 1/19 1/21 1/23 1/25 1/27 1/29 1/31 2/2 2/4 2/6 2/8 2/10 2/12 2/14 2/16 2/18

-2.00%

-4.00%

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“Google Cools Off, and Stock Drops”

The Wall Street Journal, January 20, 2012
0.04

0.02

0
1/4/12 1/8/12 1/12/12 1/16/12 1/20/12 1/24/12 1/28/12 2/1/12 2/5/12 2/9/12 2/13/12 2/17/12

-0.02

-0.04
Announcement of
2011 Q4 earnings
-0.06

-0.08

-0.1

Why Do Prices React to Financial Statement

Information?

• An application of decision theory model

• Investors have prior probabilities of future firm
performance
• Investors obtain useful information from financial
statements
• Investors revise their probabilities
• Leads to buy/sell decisions
• Trading volume increases, Security price changes

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Accounting Earnings and Stock Returns

C. Nichols and J. Wahlen. “How Do Earnings Numbers Relate to Stock

Returns? A Review of Classic Accounting Research with Updated Evidence”
Accounting Horizons (2004)
5

Finding the Market Response

• When the information first became publicly available
• The market reaction should be complete within a short-window of a
few days surrounding the date of announcement

• Whether the information is good news or bad news

• The reported result should be compared with investors’ expectation
before the announcement

• What is the market response attributable to the information

released
• Market-wide and firm-specific factors that affect share prices should
be separated

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Separating Market-Wide and Firm-Specific Factors

of Return

Unexpected Earnings
• Investors have expectations of current earnings
• Investors’ expectations are built into share price prior to
release of current earnings
• Investors will react only to unexpected earnings
• How to estimate investors’ earnings expectations
• Time series approach
• Using past earnings to predict current earnings
• Analyst forecast
• Incorporate more recent information
• On average more accurate than time-series models
• Far from perfect proxy

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The Ball and Brown (1968) Study

• The first study to provide scientific evidence that share prices
react to financial statement information.
• Methodology
• For Each Sample Firm (261 NYSE firms from 1957-1965):
• Estimate investors’ earnings expectations (proxied by last year’s earnings)
• Classify each firm as GN (actual earnings > expected earnings) or BN
(actual earnings < expected earnings)
• Estimate abnormal share return for month of earnings announcement
(month 0)
• Calculate Average Abnormal Share Return for GN and BN Firms for
Month 0
• Repeat for Months -1, -2,…,-11, and Months +1, +2,…,+6

R. Ball and P. Brown. “An Empirical

Evaluation of Accounting Income
Numbers”. Journal of Accounting
Research (1968)

Very basic question: are

accounting earnings useful?
Conclusions:
1. Significant amount of
information about a firm
during a year is captured in
that year’s income number.
2. Most of the information
content of the annual
earnings report has been
reflected by market prices
before its release.
3. But earnings
announcements still convey
new information to the
market.
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Ball & Brown Table 5

11

Why was Ball and Brown (1968) important

• The background: at 1968, the prevailing view was that accounting numbers
were meaningless.
o Managers and accountants could be constantly committing frauds and making up
numbers.
o Accounting practices are mechanical; how could they account for the drastically
different situations of different companies?

• Innovations of Ball and Brown (1968)

 A positive approach for accounting research – large sample archival study.
 Positive analyses vs. Normative analyses
 Quantitative analyses vs. Qualitative analyses
 Exploit the important concept of “efficient market hypothesis”.
 Association-study and event-study methodologies.
 Exploit machine-readable data (Compustat and CRSP).
 A lot of these may seem trivial now, but always remember we are standing
on the shoulders of giants.
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More Recent
Evidence

31,923 firm-years
from 1988-2001

Source: Nichols and

Wahlen (2004)

13

Do larger
unexpected
earnings cause
stronger
market
reactions?

Source: Nichols and

Wahlen (2004)

14

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Causation & Association

• Narrow Window Studies
• AKA short-window event studies
• Evidence that financial statement information causes security
price change
• Wide Window Studies
• AKA long-window association studies
• Evidence that financial statement information is associated with
security price change
• Narrow window studies are more powerful tests of
decision usefulness

15

Quarterly
Earnings and
Daily Return
Evidence

Source: Nichols and

Wahlen (2004)

16

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Earnings Response Coefficient (ERC)

• When firms report equal amounts of unexpected earnings,

why does the market react more strongly for some firms than
for others?

• ERC measures the extent of a security’s abnormal market

return in response to the unexpected component of reported
earnings of the firm issuing that security

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Factors Affecting ERC

• Does higher earnings quality result in higher ERC?
• For earnings quality measured by persistence: Yes
• For earnings quality measured by accruals quality: Yes
• Growth opportunities: higher growth  higher ERC
• Risk (ß): higher ß  lower ERC
• Capital structure: higher leverage  lower ERC
• Similarity of investor expectations: more similar 
higher ERC

18

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Earnings
Persistence
and the
association
between
earnings and
returns

Source: Nichols and Wahlen (2004)

19

S-Shape Earnings-
Return Relation:
Smaller ERC for
Large Earnings
Surprises

Kinney, Burgstahler, and Martin.

“Earnings Surprise ‘Materiality’
as Measured by Stock Returns.”
Journal of Accounting Research
(2002)

20

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S-Shape Earnings-Return Relation: Smaller ERC for

Large Earnings Surprises

Kinney, Burgstahler, and Martin. “Earnings Surprise ‘Materiality’ as Measured by

Stock Returns.” Journal of Accounting Research (2002)
21

Analyst Forecast
Dispersion and
ERC: Low
Dispersion

Kinney, Burgstahler, and Martin.

“Earnings Surprise ‘Materiality’
as Measured by Stock Returns.”
Journal of Accounting Research
(2002)

22

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Analyst Forecast
Dispersion and
ERC: High
Dispersion

Kinney, Burgstahler, and Martin.

“Earnings Surprise ‘Materiality’
as Measured by Stock Returns.”
Journal of Accounting Research
(2002)

23

Implications of ERC Research

• Improved understanding of market response to accounting
information suggests ways to improve the decision usefulness
of financial reporting.
• Leverage and ERC  disclosure of off-balance-sheet liabilities
• Growth opportunity and ERC  disclosure of segmental operating
information
• Earnings persistence and ERC  disclosure of components of net
income
• Should control for the impact of other ERC determinants when
evaluating the usefulness of accounting information

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Bond Market Evidence

• Easton, Monahan, and Vasvari. “Initial Evidence on the Role of Accounting
Earnings in the Bond Market”. Journal of Accounting Research (2009)

• The incidence of bond trade increases during the days surrounding

earnings announcements

• There is a bond-price reaction to the earnings announcement

• There is a positive association between annual bond returns and both

annual earnings changes and analysts forecast errors

• Stronger effects when earnings convey bad news or when bond is more
risky

25

Earnings Announcement and Bond Trading

Easton, Monahan, and Vasvari. “Initial Evidence on the Role of Accounting Earnings in the Bond
Market”. Journal of Accounting Research (2009) 26

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Bond Price Reaction to Earnings

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The Information Content of Other Financial Statement

Information

• Why does market react to other financial statement

information
• If these information relates to future cash flow
• Direct Approach
• Market reaction to other financial statement information (short
window surrounding earnings announcements)
• Indirect Approach
• Association between annual return and financial statement
information
• Financial statement information and earnings persistence

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Market Reaction to Revenue and Earnings Surprises

Jegadeesh and Livnat. “Revenue surprises and stock returns.” Journal of Accounting and
Economics (2006) 29

Ertimur, Livnat and Martikainen. “Differential Market Reactions to Revenue and Expense
Surprises” Review of Accounting Studies (2003)

30

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Lev and Thiagarajan. “Fundamental Information Analysis”

Journal of Accounting Research (1993)

31

Application Example: The Impact of Mandatory IFRS Adoption on the Information

Content of Earnings Announcements
Economies that mandated adoption of IFRS in Economies that continued to use domestic accounting
2005 standards from 2002 to 2007
Australia Brazil
Belgium Canada
Denmark China
Finland India
France Indonesia
Germany Japan
Greece Malaysia
Hong Kong Mexico
Italy New Zealand
Netherlands Taiwan
Norway Thailand
South Africa
Spain
Sweden
Switzerland
United Kingdom 32

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Landsman, Maydew, and Thornock. “The Information Content of Annual Earnings

Announcements and Mandatory Adoption of IFRS” Journal of Accounting and Economics
(2011)

33

The Impact of IFRS Adoption: Volume Analysis

34

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The Impact of
IFRS Adoption:
Comparing
Adopters and
Non-adopters

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