Devotion

“The fear of the Lord is the be-

ginning of knowledge, but fools
dispise wisdom and discipline”
 Chapter 5 :

The Value Relevance of

Accounting Information
By : Group 3
 Mnahonin, Rezky Juan B.
 Oktavian, Gilbert Rewah
 Kasehung, Nindy
 Polii, Marco Marcellino
 Refasi, Edgar Dominggus
 5.1 The Value Relevance Approach

“ Accounting information must be able to make a difference in a

decision. Otherwise the information will be irrelevant. Relevant
information can help users to make predictions about the final outcome.
“
In this learning objective, there are 3 points that we will learn:
• Assume security market efficiency
• Investors responsibility for predicting company performance
• Usefulness financial statement information that evaluated by magnitude of
security price response for that information
 5.2. Outline of the Research Problem
• Reasons for market respons
We begin by reviewing the reasons why the market price of a
firms shares may respons to financial statement information. For most
of this chapter we will confine financial statement information to
reported net income.
Consider the following predictions about investor behaviour in response to
financial statement information :
1. Investors have prior beliefs about a firms future performance that is, its
dividens, cash flow, and earnings which affect the expected returns and risk of the
firms securities. These prior beliefs will be beased on all avaible infotmation,
including market price up to just price to the release of the firms current net
income.
2. Upon release of the current periods net income periods net income,
some investors will quickly decide to become more informed by analyzing the
income number.
3. Investors who have revised their belifs about future firm performance
upward will be inclined to buy the firms shares at their current market price, and
vice versa for those who have revised their brliefs downward.
4. We world expect to observe the volume of shares traded to increase when
the firm reports its net income.
 Beaver (1968), in a well known study, examined trading volume reaction. He
found a dramatic increase in volume during the week of release of earnings
announcements.

Finding the market response :

1. Efficient market theory implies that the market will react quickly to
new information. It is important to know when the current years reported net
income fire became publicly known. If the market is going to react, it should do
so in a narrow window of a few days surrounding these dates.
2. The good or bad news in reported net income is usually evaluated
relative to what investors expected. Investors prior beliefs would have already
been revised to reflect the earlier information.
3.There are always many events taking place that affect a firms shares
volume and price.
5.3 THE BALL AND BROWN STUDY
5.3.1 Methodology and Findings

This type of research is called an event study , since it studies the

narrow window securities market reaction to a specific event, in this
case, a firm’s release of its current net income.
5.3.2 Causation Versus Association
Evaluation of security returns over a wide window, however,
opens them up to a host of other events that affect share price.
5.3.3 Outcomes of the BB Study
- analysis was based only on the sign of unexpected earnings. That is,
the information content of earnings in BB’s study was classified only
into GN or BN, a fairly coarse measure.
- accounting researchers have studied securities market response to
net income on other stock exchanges, in other countries, and for
quarterly earnings reports, with similar results.
5.4 EARNINGS RESPONSE COEFFI-
CIENTS
They showed that on average their GN firms enjoyed positive
abnormal returns, and their BN firms showed negative ones. Of course,
an average can conceal wide variation about the average. Thus, it is
likely that some firms’ abnormal returns were well above average and
others’ were well below.
5.4.1 Reasons for Differential Market Response
The demand for the GN firm’s shares will be lower the higher its beta is, other things
equal.Of course, lower demand implies a lower increase in market price and share return in
response to the GN, hence, a lower ERC.
Capital Structure, for highly levered firms, an increase, say, in earnings (before
interest) adds strength and safety to bonds and other outstanding debt, so that much of the good
news in earnings goes to the debt holders rather than the shareholders.
Earnings Quality, that we define the quality of earnings by the magnitude of the main
diagonal probabilities of the associated information system.
Growth Opportunities, one might think that since financial statements still contain a
considerable historical cost component, net income really cannot say much about the future
growth of the firm. However, this is not necessarily the case. Suppose that current net income
reveals unexpectedly high profitability for some of the firm’s recent investment projects.
5.4.2 Implications of ERC Research
Earnings quality suggests that higher earnings quality is valued
by equity investors.
Also, the finding that ERCs are lower for highly levered firms
supports arguments to expand disclosure of the nature and magnitude of
financial instruments, including those that are off balance sheet. If
the relative size of a firm’s liabilities affects the market’s response to
net income, then it is desirable that all liabilities be disclosed.
5.4.3 Measuring Investors’ Earnings Expectations
Researchers must obtain a proxy for expected earnings, since an effi-
cient market will react to only that portion of an earnings
announcement that it did not expect. If a reasonable proxy is not
obtained, the researcher may fail to identify a market reaction when
one exists, or may incorrectly conclude that a market reaction exists
when it does not. Thus, obtaining a reasonable estimate of earnings
expectations is a crucial component of value relevance research.
5.5 Measuring 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
A Caveat about the “Best” Accounting Policy (continued)

• While accounting policies that produce the highest ERC may be most
decision useful for investors, they may not be best for society.
• Accounting information as a public good
– 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
5.6 Value Relevance of Other Financial
Statement Information :
• Balance sheet
• Hard to find since more difficult to know when investors first
become aware of B/S information
• Supplementary information
• RRA: mixed evidence
• Financial statement notes
• Evidence of market response following the date firms report to SEC.
• Response driven by financial analysts who pounce on the data.
5.7 Conclusion
Security market response to accounting information supports
rational decision theory and efficient securities market theory.
Thanks