Week 6

1. Week 6 Capital Markets Research and Accounting

2. Learning Objectives • Upon completing this topic you should be able to: • Explain the role of capital market research in accounting; • Differentiate between an event study and an association study; • Outline the relationship between accounting measures of financial performance and share prices; • Identify findings of capital markets research relevant to accounting; • Explain the role of information and information intermediaries in capital markets; • Distinguish between behavioural finance findings and mainstream finance research findings; • Discuss how behavioural research contributes to an understanding of decision making.

3. Where does this fit into unit learning goals? • apply a range of theories of accounting to explain financial accounting and reporting practices and appreciate the judgements, estimations and assumptions influencing accounting numbers; • critically assess and appreciate changing influences in standard setting; the compliance regime in capital markets and impacts of regulatory requirements on financial reporting practices; • assess the role of financial accounting in sustainable development and corporate social and environmental performance reporting; • analyse a range of financial reporting issues, including intangible assets, financial instruments and foreign currency transactions, from both a practical and theoretical perspective; and • demonstrate effective individual research skills to produce professional quality business documents to solve financial accounting problems; and demonstrate in individual summative assessment tasks the acquisition of a comprehensive understanding of the topics covered by this unit.

4. Capital Market Research and Accounting • There are more than 1000 papers published examining whether accounting information informs capital markets and whether capital market based research can inform the standard setting process. • There are two primary perspectives in this research: • Information Perspective • Focuses on accounting providing information to users of financial statements about a firm’s financial condition and performance. • Measurement Perspective • Focuses on accounting amounts as measures of the firm’s resources (assets), claims to those resources (liabilities) and components of performance (revenues and expenses).

5. How Do Accounting Earnings Numbers Relate to Share Returns?

6. Capital Market Research and Accounting • Three important assumptions underlie this research. • That the accounting measure provided by financial reporting can be used by shareholders to form expectations about current and expected future profitability; • Which, in turn provides shareholders with information about dividends, both current and expected; and • These expectations will influence shareholders’ decisions to retain or to sell their shares so determining the market price of the shares.

7. Capital Market Research and Accounting • The four factors that are commonly considered by capital market researchers are: • Accounting information in the form of earnings/profitability. • Expectationsabout earnings. • Market efficiency. • Asset pricing.

8. Capital Market Research and Accounting • Accounting information in the form of earnings, may not provide useful information to capital markets because • Earnings announcements may have been pre-empted. • Accounting standards do not allow a firm to recognise certain information. • Capital market participants may suspect earnings management.

9. Capital Market Research and Accounting • Unexpected Earnings • New information conveyed by the earnings number. • Asset Pricing • Uses models that assume that shares should provide a rate of return sufficient to compensate their holders for forgoing consumption and bearing the risk associated with the shares.

10. Capital Market Research and Accounting • Market efficiency islinked with assumptions about what information is available to investors and thus reflected in the price. • Weak form: the current share price reflects all the information contained in past prices • Technical analyses that use past prices alone would not be useful in finding undervalued stocks • Semi-strong form: the current price reflects the information contained not only in past prices but all public information • No approach that was based on using and manipulating this information would be useful in finding undervalued stocks. • Strong form: the current share price reflects all information, public as well as private • No investors will be able to consistently find undervalued stocks.

11. Research Methods: Event Studies and Value Relevance • The complex relationship between accounting information and share prices makes it uncertain that accounting information causes share price reactions. • There are two main methods that are used to examine whether share prices react to accounting information: an event study and an association study.

12. Research Methods: Event Studies And Value Relevance • Event Study • Examines the changes in the level or variability of share prices or trading volume over a short time around the release of accounting or other information. • Association Study • Examineshow quickly accounting measures capture changes in the information that is reflected in share prices over a given period.

13. What The Information Perspective Studies Tell Us • Presumably earnings announcement with • Good news should cause a share price to increase. • Bad news should cause a share price to decrease. • Either should result in significant increases in trades if they are a source of information for investors. • This assertion has been broadly confirmed by numerous studies.

14. What The Information Perspective Studies Tell Us • This is good news for accounting, but studies also suggest other sources provide more timely information about earnings. • This may be interim disclosures • Also investment analysts

15. Activity 1 • Examine effect of information release on share prices • Compare to a related company

16. Prices Lead Earnings • It is theorised that the information set reflected in prices of shares contains information about future earnings. • It has been argued that conservatism and accrual principles mean accounting ‘garbles’ an otherwise ‘true’ earnings signal about firm value. • This means earnings numbers lag prices.

17. Post-Earnings Announcement Drift • Much evidence indicates that the stock market initially under-reacts to earnings information. • Then slowly incorporates the information into share price. • This appears to contradict the Efficient Markets Hypothesis.

18. Cosmetic Accounting Choices • Management has incentives to make accounting choices which bias information in their favour. • Misleading stakeholders about economic performance. • Often linked with management remuneration • Influencing contractual outcomes based on accounting numbers. • Often linked with debt covenants

19. Cosmetic Accounting Choices • Research suggests managers take advantage of discretion in methods to manage reported earnings to increase their compensation. • Also managers may also engage in ‘big bath’ accounting. • When earnings are below expectations write off additional costs to allow for improved performance subsequently.

20. Capital Markets and their Participants’ Reaction to Accounting Disclosures • Broad conclusions of information perspective studies: • Disclosures of accounting earnings numbers lead to share price changes or increases in the volume of trading. • Participants react more quickly to bad news than good. • However accounting earnings numbers are poor measures of the relevant events that are incorporated into share prices. • Managers’ behaviour suggests that they believe accounting information is used by capital market participants

21. Activity 2 • Past exam question examining release of accounting information and share price reaction

22. Whether Auditors Or Intermediaries Add Value To Accounting Information • The prevalence of audited financial statements, even when not required by legislation, indicated that capital providers consider that auditors increase credibility. • Qualified audit reports would be expected to provoke reaction from market participants. • However studies show that audit report information is already imputed into the share price.

23. Whether Auditors Or Intermediaries Add Value To Accounting Information • Financial intermediaries add value in the capital market because they use and interpret accounting data so that share prices reflect the results of their research. • Analysts’ earnings forecasts are more accurate than time-series models of earnings. • However, analysts’ forecasts have been found to be biased in an overly optimistic direction.

24. Voluntary Disclosure Theory • Voluntary disclosure literature offers the opportunity to increase understanding of the role of accounting information in firm valuation and corporate governance. • Considers issues such as • Why firms disclose • How stakeholders use the information • How information is verified and regulated

25. Voluntary Disclosure Theory • Voluntary disclosure theory predicts • Shareholders optimise disclosure policy, corporate governance and management incentives to maximise firm value. • Increased disclosure lowers information asymmetry, thus lowering the cost of capital. • But has costs associated with incentives, litigation and proprietorship. • Managers will delay disclosing good news and speed up the release of bad news.

26. Activity 3 • Examine Application Question 2 • Impact of non-accounting information on share price

27. Value Relevance • An item of accounting information is considered relevant if it has the ability to make a difference to the decisions of users. • Value relevance research has two features • It requires in-depth knowledge of accounting institutions, accounting standards and reported accounting numbers. • timeliness is not an important issue as it is in an event study.

28. The Relationship Between Relevance and Reliability, and Value Relevance

29. Value Relevance • Studies have focused on accounting information by examining: • Earnings and security returns. • The value relevance of non-earnings data. • The value relevance of different accounting practices. • The value relevance of different GAAP.

30. What Value Relevance Studies Tell Us • Studies of the world’s major stock exchanges show that any relationship evident is at best weak. • Low association between reported earnings and share prices. Possibly because: • Investors focus on all events that affect future cash flows, not those recognised by accounting. • Managers risk preferences and negative earnings. • Losses should not be considered the same as profits.

31. Relevance and Faithful Representation • It is assumed that an accounting amount will be value relevant only if the amount reflects information • That is relevant to investors, and • It has been measured reliably • Various and conflicting evidence has been presented as to the importance of various components of earnings.

32. Measurement Perspective Research • Research suggests fair values are more informative relative to historic cost. • It is suggested that the level of informativeness is affected by measurement error and the source of the estimates of fair value.

33. The Efficiency of Capital Markets • Market efficiency is important to accounting because the assumption means that investors would see through alternative or opportunistic accounting choices. • If markets are not efficient, then discretionary accruals (or earnings management) can fool investors.

34. Testing Whether Capital Markets are Efficient • Most short-window event studies are generally consistent with market efficiency. • But sometimes the market does not react quickly to information, • This ‘drift’ contradicts market efficiency. • Longer-period tests assume that the market can over or under react to new information because of human judgement and behavioural biases. • Recent evidence contradicts market efficiency.

35. Testing Whether Capital Markets are Efficient • The following specific anomalies have also been identified: • The small firm effect. • The neglect effect. • The exchange effect. • The exotic effect.

36. Behavioural Finance • There is mounting empirical evidence suggesting that existing finance theories appear to be deficient in fundamental ways. • Behavioural finance • Integrates psychology and economics. • Focuses on decision-making under uncertainty. • Shows that people rely heavily on heuristics. • Suggest individuals are not rational decision makers or wealth maximisers.

37. Cornerstones of Behavioural Finance • People make systematic errors in the way they think. • People are overconfident about their abilities. • People put too much weight on recent experience. • Separate decisions that should be combined.

38. Cornerstones of Behavioural Finance • The following principles or heuristics have been identified: • Framing • How a concept is presented to people matters. • Disposition Effect • People avoid realising paper losses but seek to realise paper gains. • Anchoring • People tend to rely on a numerical anchor value • Representativeness • People tend to rely on stereotypes • Affect heuristic • Emotions affect risk–return perceptions and investment behaviour

39. Next week • Review problems with this topic • Question provided in class • First of our practical accounting issues • Accounting for Intangible assets • We will start to use Deegan (2012) from next week