Information Perspective on Decision Usefulness

1. Information Perspective on Decision Usefulness

2. Class Announcements • Assignment #5 due on February 10th • Research paper Part #2 due on February 13th • Midterm (in-class) February 17, 2014 • Research Paper Part #1 returned at the end of class

3. Class Objectives • Market Efficiency as a precondition to the information perspective • The decision usefulness of information • Market responsiveness to information

4. Market Efficiency: Information • If markets are efficient, we should observe the market value of securities responding in predictable ways to new information • Accounting research has established that security market prices do respond to accounting information • If accounting information did not have information value there would be no revision of beliefs (i.e. no valuation/price change)

5. Market Efficiency: Implications • Efficiency implications for financial accounting • Content not form of disclosure is valued by the market • Accounting information is only one source of information used by investors and will survive if relevant. • Mechanisms must exist to enable communication of information (information asymmetry) • Our interest is in the characteristics of the market prices of securities traded in the market and how these prices are affected by new information

6. Market Efficiency: Information Asymmetry

7. Information Perspective • Equating of usefulness to information content is called the information perspective on decision usefulness of financial reporting. • Until the last few years, the information perspective has dominated financial accounting theory and practice. • Investors want to make their own predictions of future and use useful information to make those predictions. • The degree of usefulness for investors can be measured by the extent of volume or price change following the release of the information.

8. Information Perspective • “The information perspective on decision usefulness is an approach to financial reporting that recognizes individual responsibility for predicting future firm performance and that concentrates on providing useful information for this purpose. The approach assumes securities market efficiency recognizing that the market will react to useful information form any sources including the financial statements.” p. 113

9. Information Perspective: Value of Information • Market will react quickly to new information (narrow window) • Good or bad news is evaluated relative to investors expectations. • Multitude of events: impact of market-wide and firm-specific factors on share returns.

10. Information Perspective: Empirical Investigations • CAPM • Rjt = a+ βj(RMt) + e • Only firm-specific component is ßj • Research can obtain past data on Rjt and RMt and use regression analysis to estimate the coefficient of the model • Abnormal return is the rate of return on firm j’s share for day after removing the influence of market wide factors. • A positive abnormal share return constitute evident that investor are reacting favorably to unexpected good news in earning

11. Information Perspective: Empirical Investigations

12. Empirical Investigations:The Ball and Brown Study • The first study to document statistically a share price response to reported net income (1968) • Provided substantive evidence that the market reacted to good news • Stock market reacts to accounting information, but begins to anticipate the GN or BN in earnings 12 months prior to month of earnings announcement • Their methodology still in use today (event study) • Use of a wide window due to lack of daily stock information

13. Empirical Investigations:Event Window • Narrow Window Studies • Evidence that financial statement information causes security price change • Relatively few firm specific events • Suggests accounting disclosure are the source of new information • Wide Window Studies • Evidence that financial statement information is associated with security price change • Opens up to a host of other events that affect share price • Association between share returns and earnings increases as the window widens

14. Information Perspective: Empirical Investigations • Amount of abnormal share price change correlates with amount of GN/BN • Amount of abnormal share price change correlates with quarterly earnings reports • Response to balance sheet information is hard to find • Increase in volume following the week of earnings announcement

15. Empirical Investigations:Earnings Response Coefficients (ERC) • Market might respond more strongly to the good or bad news in earnings for some firms tan for other (differential market response) • An ERC measures the extent of a security's abnormal market return in response to the expected component of reported earnings of the firm issuing that security (p. 132). • Better understanding of market response yields improved decision usefulness of financial statements • Different components of income have different ERC’s

16. Empirical Investigations:Earnings Response (ERC) • Reasons for differential market responses: • 1. Beta – risk evokes weaker response • 2. Capital structure – leverage > debt holders • 3. Persistence – permanent vs. transitory • 4. Earnings quality – predictive (accruals quality) • 5. Growth opportunities • 6. Similarity of Expectations

17. Research Paper Part #2 • Part #1 – Average 2.1/2.5 • Discussion of accounting treatment related to CICA 1000- e.g. criteria for asset/liability, user need, qualitative characteristic such as relevance, etc. – choose one aspect of CICA 1000. • Due: February 13th (in-class) • Worth: 2.5% • Length: One page submission (double spaced) with Part#1 and Marking Key #1 attached to the back.