Chapter 5: The Information Approach to Decision Usefulness

1. Chapter 5: The Information Approach to Decision Usefulness • Ari Benarroch • Nazish Haq • Qin Lin • Nikhil Sequeira

2. Agenda • Overview of the chapter • Outline of research problem • The Ball and Brown Study • Earnings Response Coefficients • Unusual, Non-Recurring, and Extraordinary Items • The “Best” accounting policy

3. Overview • Accounting research shows that security prices do respond to accounting information • The ball and brown in study in 1968 provides the first solid evidence of a securities market reaction to an earnings announcement • In essence information is useful if it changes investor beliefs

4. Definition The information approach to decision usefulnessis an approach that recognizes individual responsibility for predicting future firm performance and that concentrates on providing useful information for this purpose. The approach assumes security market efficiency recognizing that the market will react to useful information from any source, including financial statements

5. What does this mean? • Investors want to make their own predictions • Research can help accountants determine what information is useful

6. Example • On March 31st 2010 Research in Motion Limited (TSE:RIM) reported earnings of US$4.02 Billion. The expected earnings were $4.18 Billion. What was the effect on RIM share price that day?

7. Outline of Research Problem Predictions about investor behaviour: • Investors have prior beliefs about firms future performance • When current income is released some investors will decide to become more informed by analyzing the income number • Buy more shares if believe firm’s performance will increase and sell shares if believe firms performance will decline • Volume of shares traded is expected to increase when firm reports net income.

8. Finding Market Response • Efficient market theory implies that the market will react quickly to new information • Good or bad news is evaluated relative to what investors expected • There are multiple events that affect a firms share price, so finding the effect of net income can be hard

9. Separating Market Wide and Firm Specific factors

10. Comparing Returns and Income • If income announcement is good news then we have a positive abnormal share return • Vice versa for bad news income announcement

11. The Ball and Brown Study • The study was the first to provide convincing scientific evidence that firm’s share returns respond to reported net income. • This type of research is called an event study. • Methodology is still in used today.

12. Methodology of B&B Study • The First Task: • Use last year’s actual earnings as a proxy for the market expectation. • Classify as GN: Actual earnings > Expected earnings • Classify as BG: Actual earnings < Expected earnings • The Second Task • Estimate abnormal share return near the time of each earnings announcement (month 0), by using procedure illustrated in Figure 5.2

13. Figure 5.3 Abnormal Returns for GN and BN Firms

14. B&B Conclusion • Stock market reacts to accounting information, but begins to anticipate the GN or BN as much as a year early. • The important in distinction between narrow and wide window studies. • Narrow window: a few days up to one month • Wide window: longer than one month

15. Causation Vs. Association • Narrow Window Study: • The accounting information is the cause of the market reaction • Wide Window Study: • The accounting information is associated with the market reaction • Prices lead earnings over a wide window • Narrow Window study provides stronger support for decision usefulness.

16. Research Paper • “ The Effect of CEO ownership on the information content of Reported Earnings” By: AlokeGhosh, Doocheol Moon. • This paper examines the relation between capital market perceptions of earnings quality and CEO Equity ownership. • The research concludes that the earnings response coefficients (ERCs) decline across higher levels of CEO ownership with an inflection point around 25% ownership. • The result suggests that, for low levels of CEO ownership, earnings are more informative about future firm performance

17. Questions • Q1. Does amount of abnormal share price change correlate with: • Amount of GN/BN? Yes/No • With Quarterly Earning Reports? Yes/No • Q2. Narrow window studies show that financial statement information is associated with security price change. True/False

18. Efficient Response Coefficient (ERC) • Why do movie go-ers respond to changes in movie opening dates? • Study by: Linar Einav and Abraham Ravid

19. Efficient Response Coefficient (ERC) • Measures the extent of a securities abnormal market return in response to the unexpected component of reported earnings of the firm issuing that security

20. Reasons for Differential Market Response • Beta: if the firms earnings are risky, the value to a risk adverse investor will be lower = lower ERC • The opposite is true for a diversified investor • Investors will react less to a security with very risky future returns

21. Reasons for Differential Market Response • Capital Structure: an increase in earnings adds strength/safety to a bond holder or other debt holder =lower ERC • “Good” news goes to a debt holder instead of a shareholder • Earnings Quality: the higher the persistency of changes in unexpected earnings changes, the higher the ERCs

22. 3 Types of Earning Events • 1) Permanent: expected to last indefinitely • 2) Transitory: affecting earrings in the current year only • 3) Price Irrelevant: zero persistency

23. Reasons for Differential Market Response • Growth Opportunities: current good news in earnings suggest growth opportunities = higher ERC • Similarity of Investor Expectations: a common info source for investor’s will create more similarities in their interpretation of a firm’s next period earnings = higher ERC • The more precise the analysts’ forecasts the more similar an investors’ earnings expectations

24. Reasons for Differential Market Response • Informativeness of Price: the more informative the price, the less informative the content of current accounting earnings = lower ERC

25. Unusual, Non-Recurring , Extraordinary Items • Extraordinary Items Characteristics (All are required to be considered extraordinary) • 1. They are not expected to occur frequently or over several years • 2. They do not typify the normal business activities of the entity • 3. They do not depend primarily on decisions or determinations by managers or owners

26. Classificatory Smoothing • Definition: Management would choose to classify unusual items above or below the operating earnings line; a.k.a smoothing out earnings. • Characteristic 3 (from previous slide) was put into place for this reason in 1989

27. 2 Problems from Section 3480 • 1) Overestimate the persistence of operating income, due to the fact that unusual and non-recurring items are not fully disclosed. • 2) Amounts and timing of unusual and non-recurring items are subject to strategic manipulation by management. • Ex: If management chooses to recognize an unusual loss currently, income from continuing operations is reduced. If this occurs over many years then previous years earnings can be overstated.

28. Theory in Practice • Have we improved financial reporting with Section 3480 in place? • Many companies were incurring substantial expenses and revenue losses due to the September 11th terrorist attacks. • Ex: Airlines were unable to fly for two days • FASB did not allow attacks to be considered extraordinary because it was too hard to differentiate between direct costs (loss of revenue for the 2 day shut down period) and indirect costs ( consumer fear of flying for safety reasons).

29. 5.6 A Caveat About the “Best” Accounting Policy • Public Good: A good such that consumption by one user does not affect the use of it for another user, whereas a private good eliminates the usefulness for other consumers. • Ex: More than one investor can use annual reports without affecting another investor. • It’s hard to charge for such products because it wouldn’t attract many consumers. One annual report can be distributed to many users. • Because of this public goods are often supplied by governmental or quasi-governmental agencies.

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