Chapter 8: Usefulness of Accounting Information to Investors and Creditors

1. Firm valuation models Efficient-markets hypothesis CAPM Cross-sectional valuation studies Company-auditor roles Accounting data and creditors Accounting allocations Information economics Chapter 8: Usefulness of Accounting Information to Investors and Creditors

2. Financial Accounting Standards Board • Primary user groups • Investors • Creditors • Cost-Benefit calculus • Cost considerations confined to producers • Benefits for investors and creditors

3. Firm Valuation Models • Dividend valuation model: value of a firm is the present value of future expected dividends to be received by stockholders • Cash flow valuation model: value of firm is the present value of future net cash flows • Theoretical literature implications are that accrual accounting systems incorporate the attribute that determines firm valuation...net cash flow data.

4. Efficient-Markets Hypothesis (EMH) • Information content: when an item of information causes a price response in the security • Three forms • Weak • Semistrong • Strong

5. Difficult to extract disclosure some accounting numbers or relationships are more difficult or costly to uncover and their effects may not be fully revealed in security prices This is contrary to the EMH assumption Noise traders individuals who do not necessarily respond in a completely rational way in terms of responding to new information in terms of their trading habits may be rebalancing their portfolios, responding to liquidity shocks or even acting upon whims Incomplete Revelation Hypothesis

6. Foundation of Capital Market ResearchPortfolio Theory • Risk can be reduced by holding a portfolio of investments • Risk types • Unsystematic (diversifiable) • Systematic (undiversifiable)

7. Capital Asset pricing Model (CAPM) • Theoretical pricing of stocks • Market assumed to be a diversified portfolio • Correlation made between returns on individual stocks and market returns • Regression analysis fits a line to the scattergraph • Slope of the characteristic line is beta

8. Security Returns vs. Market Returns + Return on Stock Return on Market Characteristic Line -

9. Rj = expected return on security j i = risk-free rate of return Rm = expected return on the market portfolio Rj = i + Bj (Rm – i) Bj = beta coefficient for security j

10. aj = the intercept from the regression ej = random error term Rj = aj + Bj (Rm) + ej Empirical studies in accounting use a simpler approach called the market model

11. Unexpected or Abnormal Returns • Captured in the error term ej • A common research approach is to regress these abnormal returns on accounting variables such as unexpected reported earnings for the same time period to determine if there is information content

12. Ball and Brown (1968) • Information content of accounting numbers • Seminal study showed the direction of change in reported earnings was positively correlated with security price movements • Not surprising...expect accounting income to be part of the information used by investors in assessing risk and return

13. Capital Market Research • Accounting earnings appear to have information content and to affect security prices • Alternative accounting policies with no apparent cash flow consequences have no information content • Alternative accounting policies with cash flow consequences do have information content

14. Capital Market Research • Incentives exist to choose certain accounting policies where choice exists, owing to indirect cash consequences • Accounting-based risk measures correlate with market risk measures, suggesting that accounting numbers are useful for risk assessment

15. Another research approach • Examine the association between accounting data reported in the financial statements and the levels of stock prices (not the abnormal returns) • Referred to as cross-sectional valuation

16. Company-Auditor Roles • Key assumption of accounting research is that financial statement information is reliable...GAAP applied on consistent basis • Jointly produced by company and auditor • Demand can be explained by agency theory • Auditor research • Qualified audit report leads to lower stock price • Big Six audits more highly valued

17. Accounting Data and Creditors • Predicting corporate bankruptcy (loan default) • Bond ratings • Interest-rate risk premiums on debt • Experimental studies of the role of accounting data in lending decisions

18. Usefulness of Accounting Allocations • Revenue recognition and the matching of costs to revenues over multiple accounting periods requires use of allocations • Criticized as arbitrary, no allocation is completely defensible against other methods • No evidence to support the contention that allocation-based financial statements are useless

19. Accounting Information Evaluation • Information economics, decision theory • Does not provide answers to normative questions • Can determine only the value of specific information for a narrowly defined decision • Limitations • Real world decision makers face more complex decisions • User diversity is an issue; behaviors may vary

20. Firm valuation models Efficient-markets hypothesis CAPM Cross-sectional valuation studies Company-auditor roles Accounting data and creditors Accounting allocations Information economics Chapter 8: Usefulness of Accounting Information to Investors and Creditors