© 2006 Pearson Education Canada Inc.5-1 Chapter 5 The Information Perspective on Decision Usefulness

© 2006 Pearson Education Canada Inc.5-2 Until the Last Few Years, the Information Perspective has Dominated Financial Accounting Theory and Practice

© 2006 Pearson Education Canada Inc.5-3 The Information Perspective Depends on Single-Person Decision Theory It is the Investor’s Responsibility to Predict Future Firm Performance and Make Investment Decisions Accountant’s Role is to Supply Useful Financial Statement Information, to Assist Investors

© 2006 Pearson Education Canada Inc.5-4 The Information Perspective Depends on Efficient Securities Market Theory The Market Can Interpret Information From Any Source (Beaver, 1973) –OK to use historical cost accounting in financial statements proper (low relevance but high reliability), supplemented by lots of information in notes to financial statements (more relevance, e.g., RRA)

© 2006 Pearson Education Canada Inc.5-5 Stock Market Response to Financial Accounting Information Hard to Prove –But now, lots of evidence that market responds to accounting information We Concentrate Mainly on the Information Content of Net Income

© 2006 Pearson Education Canada Inc.5-6 Estimation of Abnormal Share Return Based on Efficient Securities Market Theory and Market Model See Fig. 5.1 for Procedure

© 2006 Pearson Education Canada Inc.5-7 Estimation of Investors’ Earnings Expectations Under Ideal Conditions: Accretion of Discount Time Series Approach –Zero persistence: proxy earnings expectations by last year’s earnings –Complete persistence: proxy earnings expectations by change in earnings Analysts’ Forecasts –Now the most common proxy for earnings expectations

© 2006 Pearson Education Canada Inc.5-8 The Ball and Brown Study The First Study to Document Statistically a Share Price Response to Reported Net Income (1968) Methodology Still in Use Today

© 2006 Pearson Education Canada Inc.5-9 B&B Methodology For Each Sample Firm: –Estimate investors’ earnings expectations (proxied by last year’s actual) –Classify each firm as GN (actual earnings > expected earnings) or BN (vice versa) –Estimate abnormal share return for month of release of earnings (month 0), using procedure of Figure 5.1

© 2006 Pearson Education Canada Inc.5-10 B&B Methodology, Cont’d Calculate Average Abnormal Share Return for GN Firms for Month 0 Ditto for BN Firms Repeat for Months -1, -2,…,-11, and Months +1, +2,…,+6 Plot Results –See Fig. 5.3

© 2006 Pearson Education Canada Inc.5-11 Ball & Brown Conclusion Stock Market Reacts to Accounting Information, but Begins to Anticipate the GN or BN in Earnings 12 Months Prior to Month of Earnings Announcement –Consistent with securities market efficiency and underlying rational decision theory

© 2006 Pearson Education Canada Inc.5-12 Causation v. Association Narrow Window Studies –Evidence that financial statement information causes security price change Wide Window Studies –Evidence that financial statement information is associated with security price change

© 2006 Pearson Education Canada Inc.5-13 Research in Years Following Ball & Brown Does Amount of Abnormal Share Price Change Correlate With Amount of GN/BN? Yes With Quarterly Earnings Reports? Yes With Other Stock Markets, e.g. TSE? Yes Response to Balance Sheet Information? Hard to Find

© 2006 Pearson Education Canada Inc.5-14 A Different Question Earnings Response Coefficients (ERC) –Do characteristics of unexpected earnings affect magnitude of abnormal share return? Yes

© 2006 Pearson Education Canada Inc.5-15 Factors Affecting ERC Risk (ß): Higher ß  Lower ERC Capital Structure: Higher D/E  Lower ERC Earnings Persistence: Higher Persistence  Higher ERC Earnings Quality: Higher Quality  Higher ERC

© 2006 Pearson Education Canada Inc.5-16 Factors Affecting ERC, Cont’d Growth Opportunities –Higher Growth Opportunities  Higher ERC Investor Expectations –More Precise Analysts’ Forecasts  More Similar Investor Expectations  Higher ERC Firm Size?

© 2006 Pearson Education Canada Inc.5-17 More On Earnings Quality How to Measure? –Main diag. probs. of info. system –OCF/accruals (Sloan (1996)) –Fundamentals, e.g., Δ inventory/sales (Lev & Thiagarajan (1993)) A role for B/S information –Line-by-line evaluation (Ramakrishnan & Thomas (1991))

© 2006 Pearson Education Canada Inc.5-18 Implications of ERC Research Further Supports Single-Person Decision Theory and Efficient Markets Theory Importance of Full Disclosure –So that investors can evaluate earnings persistence

© 2006 Pearson Education Canada Inc.5-19 Hierarchy of Income Numbers Net income before unusual and non-recurring items, also called core earnings x x Unusual and non-recurring items x x Income from continuing operations, also called operating income x x Extraordinary items x x Net income x x

© 2006 Pearson Education Canada Inc.5-20 A Problem of Full Disclosure Extraordinary Items –CICA Handbook, Section 3480 Definition of extraordinary item –Infrequent –Not typical –Do not depend primarily on decisions of managers or owners –NB: If item is not extraordinary, it is part of operating income –Management may not separately disclose unusual & non-recurring items, thus overstating core earnings persistence

© 2006 Pearson Education Canada Inc.5-21 Impact of Unusual, Non- Recurring & Extraordinary Writeoffs on Future Core Earnings These Writeoffs Absorb Costs that Would Otherwise be Charged Against Future Core Earnings Motivation to put Core Earnings “in the Bank” by Overstating Writeoffs Report Separately the Effects of Earlier Writeoffs on Current Core Earnings?

© 2006 Pearson Education Canada Inc.5-22 Accounting Information as a Public Good A Public Good is a Good Such That Use by One Person Does Not Destroy it for Use by Another Person Accounting Information has Public Good Characteristics –Use by one person does not prevent its reuse by others Firm cannot charge for it

© 2006 Pearson Education Canada Inc.5-23 A Caveat Recall Little Theory to Choose Between Accounting Policies Under Historical Cost Accounting –E.g., straight line v. sum of years’ digits amortization What about Using the Method that Produces Greatest Market Response –E.g., if ERC using straight line  ERC using SYD, should standard setters require straight line?

© 2006 Pearson Education Canada Inc.5-24 A Caveat, Concl. Using Market Response (ERC) to Guide Accounting Policy Choice not Socially Desirable, Due to Public Good Nature of Accounting Information –Since firm cannot charge for information, investors demand more of it than socially desirable –Public good aspect of accounting information complicates standard setting