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Chapter 3

Chapter 3. Theoretical Context. Financial Analysis. ‘Extracting significant information’ Purpose? Competitors: competitive advantage Owners: control Analysts: identify mis-priced shares Employees, Creditors: security Legitimate exercise? i.e., does it yield advantage?.

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Chapter 3

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  1. Chapter 3 Theoretical Context

  2. Financial Analysis • ‘Extracting significant information’ • Purpose? • Competitors: competitive advantage • Owners: control • Analysts: identify mis-priced shares • Employees, Creditors: security • Legitimate exercise? • i.e., does it yield advantage? Financial Information Analysis

  3. Usefulness of analysis • Can accounting info. satisfy these needs? • Can analysis: • aid control, • identify advantage, etc.? • What is role of accounting info? • Is analysis viable, sustainable? • If not, why proceed? Financial Information Analysis

  4. Theory of financial analysis • Theory: • explains • predicts • contextualises • legitimises • “What is relationship between accounting information and market?” Financial Information Analysis

  5. Theoretical approaches • Objectivism • ‘reality inherent in object’ • Constructionism • ‘reality is in interplay of object and subject’ • Subjectivism • ‘reality is in eye of beholder’ Financial Information Analysis

  6. Accounting Theory • Predominantly Objectivist • Reality exists independently of experience • Firm incorporates certain realities • Reality can be measured • society has given accountants ‘authority’ to devise rules to this end • Measures can be interpreted • Interpretation provides insights on reality Financial Information Analysis

  7. Classic (Normative) Theory • Objectivist worldview • 1950s-1960s • Economic/Finance theory: • financial instruments (shares) have intrinsic value • financial accounts verify this value • analysis confirms accounting measure • ‘Accounting measures capture reality’ Financial Information Analysis

  8. Market-based research • Economic/Finance theory changes • user perspective • market determines reality • constructionist? • Accounting information: • no intrinsic value • how does it impact upon users? • Testable by empirical studies Financial Information Analysis

  9. Portfolio Theory • Finance theory • Risk • Quantifiable? • Probability-related • Past performance as basis? • Use of mean with standard deviation • Reduced through diversification • Risk decreases as portfolio increases Financial Information Analysis

  10. Capital Asset Pricing Model • Relationship between risk and return • Assumptions • investors are rational and risk-averse • market is perfect with no transaction costs • information has no cost and is free • all can borrow and lend at risk-free rate • Standard Deviation an appropriate measure of risk Financial Information Analysis

  11. CAPM • Portfolio built incrementally •  SD  • ‘Relevant’ risk is impact of marginal investment on portfolio risk • Unsystematic risk • unique to security • can be diversified away • Systematic risk Financial Information Analysis

  12. Systematic (Market) Risk • Cannot be diversified away • How can it be measured? • BETA () • index • 2 bases • risk-free (govt. bond):  = 0 • market portfolio:  = 1 • Past  taken as approximation of future  Financial Information Analysis

  13. CAPM Formula • Portfolio Risk and Return known •  formula Financial Information Analysis

  14. CAPM • Useful model of expected returns • Empirical tests confirm • Major consequences for accounting • is accounting information useful? • information regarding future prospects irrelevant • Fama and French Financial Information Analysis

  15. Arbitrage Pricing Theory (APT) • Ross - APT • Multi-index model • macro-economic factors, • interest rate, etc. • ‘Additional risks incorporated into price to reflect increased risk’ Financial Information Analysis

  16. Impact of Changes in Perspective • CAPM, APT moved focus to market/user • What is impact of accounting data on user? • Is it worthwhile analysing accounting data? • Is it worthwhile producing accounting data? • What is role of accounting, if any? • Is there a better arbiter of value/wealth? Financial Information Analysis

  17. Efficient Market Hypothesis (EMH) • Focus on market/users • Market as best captor of information • Share price as best measure of wealth • Sources of information other than accounting • All impounded immediately in share price • Stocks valued fairly in light of all available information Financial Information Analysis

  18. Efficiency • ‘Share price reflects fairly and immediately all available information’ • Efficiency? • Allocative • Operational • Informational • How does market react to information? Financial Information Analysis

  19. Weak-form • ‘Past share movements no guide to future’ • Information available: past share prices • Empirical research supports • Random walk • No ‘normal’ value • No advantage in analysing past share price • EMH in weak-form widely accepted Financial Information Analysis

  20. Semi-strong form • ‘Price reflects all publicly available data’ • most Annual Report data probably already publicly available before issued • i.e., ‘Price impounds information in Annual Report before issued’ • If no advantage accrues, what is point of: • Annual Report • Analysis of AR • Generally supported by empirical tests • Anomalies Financial Information Analysis

  21. Strong form • Price reflects all data (incl. insider info.) • Testable by identifying market reaction to insider info. • If all relevant info. impounded then there should be no effect • In fact research indicates that there is a reaction • Studies suggest that it is not sustainable Financial Information Analysis

  22. Positive Accounting Theory • Accounting developed to mediate contracts • Accounting has role as control mechanism • Assumes no ‘correct’ approach • Descriptive, not prescriptive • Shapes reality as much as describes it • Useful counter-balance to EMH • Agency theory Financial Information Analysis

  23. Agency theory • Natural ally of PAT • People (managers) motivated by self-interest • Control/Monitoring mechanism required • Role for accounting: • monitoring device • provides language in which to phrase contract • efficient medium through which to operate firm Financial Information Analysis

  24. Implications for FIA • EMH fundamentally challenged claims of ‘usefulness’ of accounting information • ‘Usefulness’ gradually re-asserted by: • Un-sustainability of Strong form of EMH • Insights from behavioural finance and economics • Fundamental Analysis and market research • Emphasises that accounting information must be: • considered in broader contexts • viewed as socially-constructed information • understood within dynamics of financial markets Financial Information Analysis

  25. Summary • Market approach challenges notions of: • usefulness of accounting information • efficacy of analysis of accounting data • However, accounting has role as: • measure of risk • means of exploiting market anomalies • source of info. for operational decision-making • Research has re-established credibility of analysis as means of gaining advantage Financial Information Analysis

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