Chapter 5: The Information Approach to Decision Usefulness

1. Michael Tam, Brenda Bell, Andrea Marchlewicz, Henry Ly and Shaun Young Chapter 5:The Information Approach to Decision Usefulness

2. Agenda • Market Response Research • Ball and Brown • Earning Response Co-Efficient • Best Accounting Policy • Value Creation in the Biotech Industry • Does Disclosure Matter • Conclusion

3. 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.

4. 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 Brown and Ball Earning Response Best Policy Articles

5. 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 Market Research Brown and Ball Earning Response Best Policy Articles

6. Firm and Market Returns

7. 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 window Market Research Brown and Ball Earning Response Best Policy Articles

8. Wide Window B&B

9. Video • Brown and Ball Theory • http://www.youtube.com/watch?v=_QDBX9KfxHM

10. 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 Brown and Ball Earning Response Best Policy Articles

11. Earnings Response Coefficients • A security’s abnormal market return in response to the unexpected portion of reported earnings • ERC = Market Research Brown and Ball Earning Response Best Policy Articles

12. Reasons for ERC differences • Beta • Capital Structure • Earnings Quality • Earnings persistence • Accruals quality • Growth Opportunities • Similarity of investor expectations • Informativeness of price Market Research Brown and Ball Earning Response Best Policy Articles

13. Implications of ERC Research • To gauge market response to information • Separate persistent and non persistent information • Extraordinary items Market Research Brown and Ball Earning Response Best Policy Articles

14. 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 investors Market Research Brown and Ball Earning Response Best Policy Articles

15. 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? Market Research Brown and Ball Earning Response Best Policy Articles

16. 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 Brown and Ball Earning Response Best Policy Articles

17. 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 Market Research Brown and Ball Earning Response Best Policy Articles

18. 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 Brown and Ball Earning Response Best Policy Articles

19. Bruce McConomy; Bixia Xu Value creation in the biotechnology industry

20. 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 firms Market Research Brown and Ball Earning Response Best Policy Articles

21. 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 Market Research Brown and Ball Earning Response Best Policy Articles

22. Porter’s Traditional Value Chain Supporting Activities: Company Infrastructure Human Resource Mgmt Information Systems Procurement Financing Outbound logistics Marketing & sales Primary Activities: Inboundlogistics Operations Service

23. The Biotech Value Chain Supporting Activities: Intellectual Property Protection (Legal) Facilities (Contract Research Organization) Procurement (Contract Manufacturers) Human Resources Management Information Systems Strategy Financing Investor Relations Primary Activities: R&D Pre-Clinical Trial Investigational New Drug Stage Phase I Clinical Trial Phase II Clinical Trial Phase III Clinical Trial FDA Final Approval

24. The Biotech Value Chain • Three main contributors of the biotech value chain • R&D • Compliance with government regulations; government approval • Strategic alliances

25. 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? Market Research Brown and Ball Earning Response Best Policy Articles

26. 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 Market Research Brown and Ball Earning Response Best Policy Articles

27. 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 Market Research Brown and Ball Earning Response Best Policy Articles

28. 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? Market Research Brown and Ball Earning Response Best Policy Articles

29. 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 Market Research Brown and Ball Earning Response Best Policy Articles

30. 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? Market Research Brown and Ball Earning Response Best Policy Articles

31. Points of View 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?

32. Conclusion

33. Recommendation • Expanded management discussion and environmental analysis • A revision of reporting under some uncertainty • Increased Auditor consideration of environmental risk Market Research Brown and Ball Earning Response Best Policy Articles

34. Questions?