CH 10

Financial Accounting Theory Craig Deegan
Chapter 10 Reactions of capital markets to financial reporting Slides written by Craig Deegan and Michaela Rankin
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
10-1
Learning objectives
In this chapter you will be introduced to
the role of capital market research (CMR) in assessing the information content of accounting disclosures the assumptions of market efficiency typically adopted in capital market research the difference between capital market research that looks at the information content of accounting disclosures, and capital market research that uses share price data as a benchmark for evaluating accounting disclosures
10-2
Learning objectives (cont.)

why unexpected accounting earnings and abnormal share price returns are expected to be related the major results of capital market research into financial accounting and disclosure
10-3
Capital market researchintroduction

Explores the role of accounting and other financial information in equity markets Involves examining statistical relations between financial information and share prices Reactions of investors evident from capital market transactions No share price change implies no reaction to particular information
10-4
Capital market versus behavioural research

Capital market research
assesses the aggregate effect of financial reporting on investors considers only investors
Behavioural research
analyses individual responses to financial reporting examines decision-making by many groups
e.g. bank managers, loan officers, auditors
10-5
Reasons for capital market research

Information about earnings and its components is the primary purpose of financial reporting Earnings are oriented towards the interests of shareholders Earnings is the number most analysed and forecast by security analysts Reliable data on earnings is readily available
10-6
Underlying assumption of CMREMH

CMR relies on the assumption that equity markets are efficient
in accordance with Efficient Market Hypothesis (EMH)
Efficient market defined as a market that adjusts rapidly to fully impound information into share prices when the information is released
10-7
Three forms of market efficiency

Weak form: prices reflect information about past prices and trading volumes Semi-strong form: all publicly available information is rapidly and fully impounded into share prices in an unbiased manner when released
most relevant for accounting-based capital market research
Strong form: security prices reflect all information (public and private)
10-8
Market efficiencyimplications for accounting

If markets are efficient they will use information from various sources when predicting future earnings If accounting information does not impact on share prices then it is deemed not to have any information value above that currently available
10-9
Earnings/return relation
Share prices are the sum of expected future cash flows from dividends, discounted to their present value using a rate of return commensurate with the companys risk Dividends are a function of accounting earnings Unexpected earnings rather than total earnings expected to be associated with a change in share price
10-10
Earnings/return relationmarket model

Used to separate out firm-specific share price movements from market-wide movements
derived from the Capital Asset Pricing Model
Assumes investors are risk averse and have homogeneous expectations Its use allows the researcher to focus on share price movements due to firm-specific news
10-11
Earnings/return relationmarket model (cont.)

Total or actual returns can be divided into
normal (expected) returns given market-wide movements abnormal (unexpected) returns due to firm-specific share price movements
Abnormal returns used as an indicator of information content of announcements
10-12
Results of CMRBall and Brown (1968) study

Examined data from 261 US firms Tested whether firms with unexpected increases in accounting earnings had positive abnormal returns, and firms with unexpected decreases had negative abnormal returns Found that
information contained in the annual report, prepared using historical cost was useful to investors 85 to 90% of earnings announcement is anticipated by investors much of information is obtained from other sources
10-13
Results of CMRextent of alternative information sources

Information content varies between countries and companies Compared to US markets, Australian market had slower adjustments during the year with larger adjustments at earnings announcement
less alternative sources of information for Australian market
Less alternative sources of information for smaller firms than larger firms
10-14
Results of CMRpermanent and temporary changes

Research examined relationship between the magnitude of unexpected changes in earnings (EPS) and magnitude of abnormal returns
known as the earnings response coefficient a 1% unexpected change in earnings associated with 0.1 to 0.15% abnormal return depends on whether earnings increases expected to be permanent or temporary
10-15
Results of CMRrelative magnitudes of cash and accruals

Earnings persistence depends on proportion of accruals relative to cash flows
firms with large accruals relative to actual cash flows unlikely to have persistently high earnings
Share prices found to act as if investors fixate on reported earnings without considering relative magnitudes of cash and accrual components
10-16
Results of CMRinformation announcements of other firms

Earnings announcements by one firm also results in abnormal returns to other firms in the same industry Related to whether the news reflects a change in conditions for the entire industry, or changes in relative market share within the industry
10-17
Results of CMRinformation content of earnings forecasts

Announcements of expected earnings rather than actual earnings are associated with share returns Management and security analysts both make forecasts
10-18
Results of CMRbenefits of voluntary disclosure

Voluntary disclosures include those in annual reports as well as media releases etc. Firms with more disclosure policies have
larger analyst following and more accurate analyst earnings forecasts increased investor following reduced information asymmetry reduced costs of equity capital
10-19
Results of CMRrecognition versus footnote disclosure

Recognising an item in the financial statements is perceived differently to disclosure in footnotes Investors place greater reliance on recognised amounts than on disclosed amounts
10-20
Results of CMRsize
Relationship between earnings announcements and share price movements is inversely related to the size of the entity Earnings announcements found to have a greater impact on share prices of smaller firms than larger firms More information generally available for larger firms
10-21
Do current prices anticipate future announcements?

As firm size increases, share prices incorporate information from wider number of sources
relatively less unexpected information when earnings are announced
May be able to argue that share prices anticipate future earnings announcements for larger firms with some accuracy
10-22
Accounting earnings reflecting information

Rather than determining whether earnings announcements provide information, recent research examines whether earnings announcements reflect information that has been already used by investors
looking back the other way market prices viewed as leading accounting earnings
10-23
Accounting earnings reflecting information (cont.)

Share prices are considered as benchmark measures of firm value Share returns are considered as benchmark measures of firm performance Benchmarks are then used to compare usefulness of alternative accounting and disclosure methods Based on premise that market values and book values are both measures of firm value
10-24
Accounting earnings reflecting information (cont.)

If market value is related to book value, returns should be related to accounting earnings per share, divided by price at the beginning of the accounting period
provides an underlying reason why we should expect returns to be related to earnings over time
10-25
Results of CMRaccounting earnings reflecting information

Beaver, Lambert and Morse (1980) found share prices and related returns were related to accounting earnings Because of various information sources, price appeared to anticipate future accounting earnings Supported by Beaver, Lambert and Ryan (1987)
10-26
Results of CMRaccounting earnings reflecting information (cont.)

Dechow (1994) found over short intervals earnings are more strongly associated with returns than are realised cash flows
the ability of cash flows to measure firm performance increases as the measurement interval increases
10-27
Results of CMR accounting earnings reflecting information (cont.)

Studies examining which asset value approaches provide accounting figures that best reflect market valuation found
fair value estimates of banks financial instruments seem to provide a better explanation of bank share prices than historical cost (Barth, Beaver & Landsman 1996) revaluation of assets results in better alignment of market and book values (Easton, Eddy & Harris 1993)
10-28
Relaxing assumptions about market efficiency

Recent years have seen a number of researchers questioning some assumptions about market efficiency Market reactions to information often found to be longer than would be anticipated from an efficient market. Also market found to sometimes underreact to particular announcements Created new areas for researchfor example what factors influence earnings drift So, should we reject research that has embraced the EMH?
10-29

CH 10

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Financial Accounting Theory Craig Deegan

Learning objectives (cont.)

Capital market researchintroduction

Capital market versus behavioural research

Reasons for capital market research

Underlying assumption of CMREMH

Three forms of market efficiency

Market efficiencyimplications for accounting

Earnings/return relationmarket model

Earnings/return relationmarket model (cont.)

Abnormal returns used as an indicator of information content of announcements

Results of CMRBall and Brown (1968) study

Results of CMRextent of alternative information sources

Results of CMRpermanent and temporary changes

Results of CMRrelative magnitudes of cash and accruals

Results of CMRinformation announcements of other firms

Results of CMRinformation content of earnings forecasts

Results of CMRbenefits of voluntary disclosure

Results of CMRrecognition versus footnote disclosure

Do current prices anticipate future announcements?

Accounting earnings reflecting information

Accounting earnings reflecting information (cont.)

Accounting earnings reflecting information (cont.)

Results of CMRaccounting earnings reflecting information

Results of CMRaccounting earnings reflecting information (cont.)

Results of CMR accounting earnings reflecting information (cont.)

Relaxing assumptions about market efficiency

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