Financial Accounting Theory

Seventh Edition

William R. Scott

Chapter 5The Information Approach to Decision

Usefulness

Chapter 5 The Value Relevance of Accounting Information

5.1 The Value Relevance 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

– Helps accountants to evaluate decision usefulness of different

accounting policies

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

Outline of the Research Problem (continued)

• Abnormal share return

– Most value relevance studies examine effect of earnings information

on return on firms’ common shares

– Total share return = return due to market-wide factors ±±±± abnormal

return due to firm-specific factors

• Abnormal share return can be attributed to financial accounting

information

• If good news in financial statements leads to positive abnormal share

returns (and vice versa), conclude financial statement information is useful.

• To reach such a conclusion, need to separate market-wide and firm-

specific share return

>> Continued

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

Outline of the Research Problem (continued)

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

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

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

5.3 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

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

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

B&B Results

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

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

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 in earnings?

• Amount of GN/BN = expected earnings - actual earnings

• Answer: Yes

– With quarterly earnings reports? Yes

– On other stock markets? Yes

5.4 Earnings Response Coefficients

• A different question

– Does quality of earnings affect magnitude of abnormal share return?

• Conceptually, quality of earnings is measured by the main diagonal

probabilities of the information system

– Higher main diagonal probabilities implies higher quality

• In practice, earnings quality often measured by:

– Earnings persistence

» higher persistence →→→→ higher quality

– Accruals quality

» DeChow & Dichev (2002)): higher accruals quality →→→→ higher earnings quality

Definition of ERC

•An earnings response coefficient (ERC) is

abnormal share return divided by unexpected

earnings

– That is, ERC is abnormal share return per dollar of

unexpected earnings

•Question then is

– Does higher earnings quality result in higher ERC?

• For earnings quality measured by persistence: Yes

• For earnings quality measured by accruals quality: Yes

5 - 19

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

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 - 22

Reasons for Studying ERCs

• ERC research has greatly improved accountants’

understanding of how market responds to reported earnings

• Better understanding enables preparation of more useful

financial statements

– E.g., Financial reporting policies that produce a higher ERC are more

decision useful for investors

5.4.3 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

– Are analysts biased?

5 - 23

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

• MD&A:

• Li (2010), Section 3.6.4

• Brown & Tucker (2011), Section 3.6.4

5 - 25

5.7 Conclusion

• Security market response to accounting information supports

rational decision theory and efficient securities market theory