You are on page 1of 25

Financial Accounting Theory

Sixth Edition
William R. Scott

Chapter 5
The Information Approach to
Decision Usefulness
5-1
Copyright © 2012 Pearson Canada Inc
Chapter 5
The Information Approach to Decision Usefulness

5-2
Copyright © 2012 Pearson Canada Inc
5.1 The Information Approach

• Assumes securities market efficiency


• Investors responsible for predicting future firm
performance
– Role of financial reporting to provide useful information
for this purpose
• Usefulness of financial statement information
evaluated by magnitude of security price
response to that information

5-3
Copyright © 2012 Pearson Canada Inc
5.2. Outline of the Research Problem

• Reasons for market response


– 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
• Security price and share return change

>> Continued

5-4
Copyright © 2012 Pearson Canada Inc
Outline of the Research Problem
(continued)

• Abnormal share return


– Total share return = return due to market-wide factors ±
abnormal share return due to firm-specific factors
• Only abnormal share return can be attributed to financial
accounting information
• If good news in financial statements leads to positive
abnormal share return (and vice versa), conclude financial
statement information is useful.
• To reach such a conclusion, need to separate market-wide
and firm-specific returns

>> Continued

5-5
Copyright © 2012 Pearson Canada Inc
Outline of the Research Problem
(continued)

• Separating market-wide and firm-specific returns


– Firm releases financial information
• Most studies look at release of earnings
– Use a market model to estimate market-wide return on
that day (or narrow window)
• Assumes market efficiency
– Abnormal share return during narrow window = total
return – market-wide return
– See Figure 5.2

» Continued

5-6
Copyright © 2012 Pearson Canada Inc
Outline of the Research Problem
(continued)

5-7
Copyright © 2012 Pearson Canada Inc
Outline of the Research Problem
(continued)

• Unexpected earnings
– Investors have expectations of current earnings
– Investors’ expectations are built into share price prior to
release of current earnings
• Assumes market efficiency
– When current earnings released, investors will react only
to unexpected component
– Investors’ earnings expectations unobservable
– How to estimate unexpected earnings?

>> Continued

5-8
Copyright © 2012 Pearson Canada Inc
Outline of the Research Problem
(continued)

• Estimation of investors’ earnings expectations


– Time series approach
• Based on earnings in prior years
– Analysts’ forecasts
• Available for most large firms
• Now the most common approach

5-9
Copyright © 2012 Pearson Canada Inc
Outline of the Research Problem
(continued)

• Finally, compare abnormal share return with


unexpected earnings
– If positive unexpected earnings is correlated with
positive abnormal share return, and vice versa,
suggests earnings information is decision useful

5 - 10
Copyright © 2012 Pearson Canada Inc
5.3 The Ball and Brown Study

• The first study to document statistically a share


price response to firm-specific component of
reported net income (1968)

• Methodology still in use today

5 - 11
Copyright © 2012 Pearson Canada Inc
The Ball and Brown Study (continued)

• B&B methodology
– For Each Sample Firm:
• Estimate investors’ earnings expectations (proxied by last
year’s actual)
• Classify each firm as GN (actual earnings > expected
earnings) or BN (vice versa)
• Estimate abnormal share return for month of release of
earnings (month 0), using procedure of Figure 5.2

» Continued

5 - 12
Copyright © 2012 Pearson Canada Inc
The Ball and Brown Study (continued)

• B&B methodology (continued)


– Calculate Average Abnormal Share Return for GN Firms
in the sample for Month 0
– Ditto for BN Firms
– Repeat for Months -1, -2,…,-11, and Months +1, +2,…,+6
– Plot Results
• See Fig. 5.3, next slide

5 - 13
Copyright © 2012 Pearson Canada Inc
B&B Results

5 - 14
Copyright © 2012 Pearson Canada Inc
The Ball and Brown Study (continued)

• B&B conclusion
– Stock market reacts to earnings information in month
zero, but begins to anticipate the GN or BN in earnings
12 months prior
– Consistent with securities market efficiency and
underlying rational decision theory

>> Continued

5 - 15
Copyright © 2012 Pearson Canada Inc
The Ball and Brown Study (continued)

• Causation v. association
– Narrow Window Studies
• Evidence that financial statement information causes
security price change
– B&B month zero is narrow window
– Wide Window Studies
• Evidence that financial statement information is associated
with security price change
– B&B months -12 to -1 and 1 to 6 are wide window
– Narrow window studies more consistent with decision
usefulness
>> Continued

5 - 16
Copyright © 2012 Pearson Canada Inc
The Ball and Brown Study (continued)

• Research in years following Ball & Brown


– Does Amount of Abnormal Share Price Change
Correlate With Amount of GN/BN? Yes
– With Quarterly Earnings Reports? Yes
– On Other Stock Markets? Yes
– Response to Balance Sheet Information? Hard to Find
• Why?

5 - 17
Copyright © 2012 Pearson Canada Inc
5.4 Earnings Response Coefficients

• A different question
– Do characteristics of unexpected earnings affect
magnitude of abnormal share return?
– Yes

>> Continued

5 - 18
Copyright © 2012 Pearson Canada Inc
Earnings Response Coefficients
(continued)

• Characteristics affecting ERC


– Risk (ß): higher ß  lower ERC
– Capital structure: higher D/E  lower ERC
– Earnings quality:
• higher quality  higher ERC
• Important components of earnings quality
– Earnings persistence:
» higher persistence  higher ERC
– Accruals quality
» DeChow & Dichev (2002)): higher accruals quality implies higher earnings
quality

>> Continued

5 - 19
Copyright © 2012 Pearson Canada Inc
Earnings Response Coefficients
(continued)

• Factors affecting ERC (continued)


– Growth opportunities: higher opportunities, higher ERC
– Similarity of investor expectations: more similar, higher
ERC
– Informativeness of price: more informative, lower ERC
• Firm size as proxy?

>> Continued

5 - 20
Copyright © 2012 Pearson Canada Inc
Earnings Response Coefficients
(continued)

• A refinement of investors’ earnings expectations


– Time series approach
• Depends on earnings persistence
– Earnings 100% persistent
» Unexpected earnings = change in earnings
– Earnings zero persistence
» Unexpected earnings = current year’s earnings

– Analysts’ forecasts approach


• Evidence suggests more accurate than time series
– Unexpected earnings = analyst forecast error
– Older forecasts tend to be less accurate
– Are analysts biased?

5 - 21
Copyright © 2012 Pearson Canada Inc
5.5 A Caveat about the “Best”
Accounting Policy
• Suppose that one accounting policy generates
higher ERC than another
– E.g., straight line v. declining balance amortization
– Is the higher ERC policy more decision useful to
investors? Yes
– Is the higher ERC policy socially preferred? Not
necessarily.
• Accounting information as a public good (next slide)

>> Continued

5 - 22
Copyright © 2012 Pearson Canada Inc
A Caveat about the “Best”
Accounting Policy (continued)
• Accounting information as a public good
– A public good is a good such that use by one person
does not destroy it for use by another person
– Accounting information has public good characteristics
• Use by one person does not prevent its reuse by others
– Thus firm cannot charge users for accounting
information

» Continued

5 - 23
Copyright © 2012 Pearson Canada Inc
A Caveat about the “Best”
Accounting Policy (continued)
• Accounting Information as a Public Good (continued)
– Investors who do not pay for accounting information will
demand more of it than socially desirable
– Implication is that standard setters cannot be sure that
an accounting policy that has a higher ERC than another
is socially better.
– Complicates standard setting

5 - 24
Copyright © 2012 Pearson Canada Inc
5.7 Conclusion

• Security market response to accounting


information supports rational decision theory and
efficient securities market theory

5 - 25
Copyright © 2012 Pearson Canada Inc