Chapter 5:The Information Approach to Decision Usefulness

Michael Tam, Brenda Bell, Andrea Marchlewicz, Henry Ly and Shaun Young

Agenda

Market Response Research Ball and Brown Earning Response Co-Efficient Best Accounting Policy Value Creation in the Biotech

Industry Does Disclosure Matter Conclusion

The Information Approach

Rational investors in an efficient market make their own predictions as to the value of firms and accounting is used to provide information for this purpose

Information is deemed useful if it changes the investors’ beliefs, which will cause a market response.

Market Response Research Investors have prior beliefs on firm

value Rational investors will seek out new

information to revise their beliefs They will buy or sell shares based on

their new beliefs Volume of traded shares will increase

and share price will change Beaver study

Market Research

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Market Response Research Tests for changes in share price due

to information Timing of information release

Earnings Good News (GN) or Bad News (BN)

Based on prior expectations of investors Other factors of share price

Market-wide vs Firm-specific returns Rjt = αj + βjRMt + Єjt

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Firm and Market Returns

Brown and Ball (1968)

Market response study as outlined Used prior year Net Income as the

expectation Done using monthly returns because

that was the best data available at the time

Results: Good News associated with positive abnormal returns and vice versa

Repeated with a wide windowMarket

Research

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Wide Window B&B

Video

Brown and Ball Theory

http://www.youtube.com/watch?v=_QDBX9KfxHM

Impact of Ball & Brown

Basis of future research

Beaver, Clarke, and Wright The greater the magnitude of the

unexpected earnings, the greater the magnitude of the price change

Market Research

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Earnings Response Coefficients

Market Research

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Response

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A security’s abnormal market return in response to the unexpected portion of reported earnings

ERC =

Reasons for ERC differences

Beta Capital Structure Earnings Quality

Earnings persistence Accruals quality

Growth Opportunities Similarity of investor expectations Informativeness of price

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Implications of ERC Research

To gauge market response to information

Separate persistent and non persistent information Extraordinary items

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The “Best” Accounting Policy

In theory the “best” policy is to maximize ERC Useful information with increase ERC Firms should disclose all useful

information Other considerations

Public vs Private goods Cost vs Benefit Impact beyond the corporation and

investorsMarket

Research

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Public vs Private Goods

Public Good: consumption by one person doesn’t prevent its use by another (e.g. roads)

Private Good: consumption by one person prevents its use by another (e.g. an apple)

What would you consider accounting information to be? A private or public good?

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The “Best” Accounting Policy

This can cause inequality between supplying the “right” amount of information versus the benefits investors gain from the information

Does maximization of ERC benefit society? Cost-benefit trade-off between the

company, investors, and the public Accounting standard setters must

beware of using market responses to create their accounting policies

Market Research

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The Information Content Of Other Financial Statement Information

Inconclusive evidence as to the usefulness of other financial statement information

Difficult to study More timely sources of this information Difficult to pinpoint release of

information Information is released simultaneously

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The Information Content Of Other Financial Statement Information

Indirect approach: Impact of GN or BN on the ERC

12 “fundamentals” by Lev and Thiagarajan used to evaluate earnings quality

Concluded that non earnings information explains abnormal returns not from earnings

Market Research

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Value creation in the biotechnology industry

Bruce McConomy; Bixia Xu

The Biotechnology Industry

Biotechnology : creates innovative products and technology by applying living organisms to different science fields

Rise of biotechnology: Canada 2010 valued at $86.5 billion

Areas of biotechnical firms: Health Care Food & Agriculture Intellectual Property Industrial & Environmental

Article focus: Biotech health care firmsMarket

Research

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Biotech Health Care Firms

Purpose: to develop and produce drugs Products under development, generally not for

sale—NOT your typical pharmaceutical company

New value chain

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Porter’s Traditional Value Chain

Primary Activities: Inbound logistics

Operations

Outboundlogistics

Marketing& sales Service

Supporting Activities: Company InfrastructureHuman Resource Mgmt

Information SystemsProcurementFinancing

Primary Activities: R&D

Pre-ClinicalTrial

Investigational New Drug Stage

Phase I Clinical Trial

Phase II Clinical Trial

Phase III Clinical Trial

FDA Final Approval

Supporting Activities: Intellectual Property Protection (Legal)Facilities (Contract Research Organization)Procurement (Contract Manufacturers)Human Resources Management

Information Systems Strategy Financing Investor Relations

The Biotech Value Chain

The Biotech Value Chain Three main contributors of the biotech value

chain R&D Compliance with government regulations;

government approval Strategic alliances

Non-financial Security Measures Question: based on what you know about

decision theory and the development of products in the biotech sector, what is the useful information needed by investors when re-evaluating their future expectations of a biotechnical firm?

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Value Creation vs Recognized Earnings

Drug development is a substantially long process, value creation can take a long time to be realized in earnings Non-financial disclosure is extremely important

Disclosure becomes more important as you near the end of the research and development cycle

R&D is a better measure of future firm performance than is the reported earnings

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Non-financial Disclosure

The lag between a biotech’s stock price and the accounting system can be resolved by disclosing non-financial performance

Such disclosures include: Report to shareholders Press releases Web site disclosures Regulatory filings

Managers in the biotech industry have greater reason to manage disclosure

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Implications of Disclosure

QUESTION: Non-financial disclosures are important in forming future expectations of investors; however, what could be the negative implications of disclosing this information?

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Summary: Biotech Disclosure

Earnings, and other financial statement figures, are not the only factors in shaping the expectations of investors

The lag between revenue recognition in earnings can be solved with non-financial statement disclosure.

The importance of disclosing the successes and failures during the R&D process can be carried over to the other areas of the biotechnical industry

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Does Disclosure Matter?

Self Regulation Versus Standards Section 3061- High Quality of

Information Is the Information provided

Relevant? Does this information provide value

to a firm?

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Points of ViewManager Standard

SettersShareholders

Based on your point of View:Is Environmental Standards required and what specifically should be required?

What are your goals for Financial Statements?

Will this result in a Benefit to Society?

Conclusion

Managers Standard Setters

Stakeholders

Advantages of Disclosure

•Can bring a lower cost of capital•Enhance interest by Institutional Investors

•Increased Transparency•Consistency Across Companies•Integration into financial reporting

•Increased Transparency•Provides credible information•Keeps companies held responsible•Reduces potential risk

Disadvantages of Disclosure

•Costly•Will hurt the reputation of the company•Risk of credibility with partial disclosure

•Can be costly to society•Must balance the cost versus benefit

Recommendation

1. Expanded management discussion and environmental analysis

2. A revision of reporting under some uncertainty

3. Increased Auditor consideration of environmental risk

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Questions?