Section 3

Financial statements as a source of

information

“Accounting is the language of business.”

--Warren Buffett
Learning objectives

After studying this chapter, you will understand

• Why financial statements are a valuable source of
information for the stakeholders of the firm
• How the demand for financial statement information
comes from its ability to improve decision making
• How the supply of financial statement information is
influenced by cost and benefit considerations
• The role of financial statement information in capital
markets
• What factors influence earnings quality

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Why financial reports are used?

• Without adequate information, we cannot properly judge

the opportunities and risks of investment alternatives
• Financial reports are often the only publicly available
source of information about a firm’s past performance,
current health, and prospects for the future

Financial statements • Analytical tool

can be used for various • Management report card
purposes: • Early warning signal
• Basis for prediction

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Economics of accounting information

SUPPLY

DEMAND

Financial statements are The supply of financial

demanded because of their
value as a source of
information about company
performance, financial condition,
and stewardship of resources.
information is guided by the
costs of producing and
disseminating it and the
benefits it will provide to the
company.

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Demand for financial statements
Shareholders • Investment
and investors decisions
• Performance assessment
Managers and • Compensation contracts
employees • Company-sponsored pension plans

Lenders and • Lending decisions

suppliers • Covenant compliance
• Seller’s health
Customers • Repeat purchases
• Warranties & support
• Mandatory reporting
Government &
• Taxing authorities
regulators
• Regulated industries

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Supply of financial statements

• Mandated reporting is designed to insure minimum levels of

reporting
• Companies frequently make voluntary disclosures that go
beyond the minimum requirements
– Guided by cost/benefit considerations.

Disclosure benefits Disclosure costs

• Low cost access to capital • Information production
• Avoid the “ lemons” problem • Competitive disadvantage
• Litigation exposure
• Political exposure

• Companies having different financial reporting costs and

benefits choose different accounting and reporting practices

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Example: Outotec, Interim report Q2/2015

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 Dechow et al. (2014), Figure 2
Investors’
reactions:
Firms with
positive
Net Income
surprise

An investor’s three favorite words:

“Better than expected”…

Firms with
negative
Net Income
surprise

Notes: Sample consists of US firms. Time period from 1971-2012. A positive (negative) annual
change in earnings defines a positive (negative) earnings surprise. Abnormal returns are market
adjusted returns using the CRSP equal-weighted return.
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Earnings and stock prices:
Evidence on value relevance
The test:
Stock Earnings
• If investors use accrual earnings to price per
price stocks, then earnings share
Random
differences across firms should error
explain differences in stock prices Stock Earnings multiple
price at (should be
$0 EPS statistically positive)

Regression
Result:
 Dechow et al. (2014): The adjusted R2 of
annual cross-sectional price regressions

Notes: Prices are measured 3 months after the fiscal year-end. Earnings per share is measured as income
before extraordinary items (IB) divided by common shares outstanding (CSHO) from Compustat. Earnings
before special items is measured as income before extraordinary items (IB) less special items (SPI) divided
by common shares outstanding (CSHO) from Compustat. “Street” earnings per share is the actual annual
EPS reported by I/B/E/S. CFO per share is measured as cash flow from operations (OANCF) divided by
CSHO from Compustat. Free cash flow is measured as cash flow from operations (OANCF) plus cash flow
from investing (IANCF) divided by CSHO. Net cash flow is measured as the annual change in cash balance
(ΔCH) divided by CSHO from Compustat. 10
Other sources of information

• Firms disclose also other important information

• Scheduled announcements
– Preliminary financial statement information
– Capital Market Days etc.
• Unscheduled announcements
– profit warnings
– major business contracts
– merger and acquisitions
– major capital expenditure decisions

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Summary

• Financial statements are a valuable source of

information about the firm’s past performance, current
health, and prospects for the future
• Supply of financial information is guided by the costs
and benefits of producing and disseminating it
• Earnings and stock prices are strongly related
• Earnings quality is influenced by firms’ own choices but
also non-discretionary factors out the firm’s hands
• Firms disclose also other information

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