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

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

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.

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 Investors do not want an accountant to provide a valuation. They will develop their own valuation and use any new information to modify their beliefs. If they now believe the shares are under- or over-valued they will buy or sell, respectively. The purpose of Financial Statements is to release information to allow investors to make appropriate valuations. As such, accounting information is useful if it changes investors opinions and thereby triggers buy/sell decisions. Based on this, the release of useful information will cause an increase in volume traded and a change in share price. Evidence of market response in Beaver study showing increased trading volume upon Market Research Brown and Ball Earning Response Best Policy Articles

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 Because efficient markets react quickly to information means research requires specific knowledge of when the information was released. Earnings is the most researched because it is widely publicized giving a more accurate date of information release than other financial information. Usually the 3 or 5 day period around release because the information may leak early and some investors may be slower at responding. Whether the information is Good News or Bad News is whether it is less than or more than the investor expectations. Options for expectations range from the same Earnings as the previous year, assuming full persistence, or zero, assuming no persistence. Easton and Harris study concluded that it was somewhere in the middle of these. To remove as many other factors affecting share price, we need to separate the firm and market returns. The first to terms show the expected market return while the final term is the abnormal return for a given firm, which is what we are looking for. Market Research Brown and Ball Earning Response Best Policy Articles

Firm and Market Returns

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 This narrow window study showed that the good or bad news from accounting information is probably the cause of abnormal returns, which supports the decision usefulness of information. However Ball and brown extended the time frame to 18 months in a wide window study Market Research Brown and Ball Earning Response Best Policy Articles

Wide Window B&B These results show that prices gradually change in advance of the release of earnings. Which shows that investors use other information to have an idea of whether they will receive good or bad news. This accounted for 85-90% of the price change. This association of historical accounting based Earnings with share price means that over a long period of time the results are the same as under ideal conditions. However as previously noted this accounting information on earnings is useful in the short term.

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

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 The B&B study laid an important part of the framework for modern accounting theory. The next step was the BCW study that, using a similar methodology, established that when the greater the magnitude of the unexpected earnings (good or bad) the greater the magnitude corresponding abnormal return. The most important extension went a step further than this and is the Earnings Response Coefficient Market Research Brown and Ball Earning Response Best Policy Articles

Earnings Response Coefficients A security’s abnormal market return in response to the unexpected portion of reported earnings ERC = Abnormal share return Unexpected earnings for the period Market Research Brown and Ball Earning Response Best Policy Articles

Reasons for ERC differences Beta Capital Structure Earnings Quality Earnings persistence Accruals quality Growth Opportunities Similarity of investor expectations Informativeness of price Beta- used to measure risk- for risk adverse investors- high beta= high risk= less demand Capital structure- for a highly leveraged firm/ higher risk= low ERC (good news in earnings go to debt holders) Earnings quality High earnings quality= higher erc, If earnings are expected over the long run Accruals- current period working capital accruals show up as cash flows next period- anticipating future cash flows Growth opportunities High ERC= high opportunity for growth in the future Similarity Investors expectations as a whole differs, then the abnormal market returns will balance out creating a lower ERC Informative of price ?? Disclude Discussion- pros and cons?? Ask prof to post slides before class?? Market Research Brown and Ball Earning Response Best Policy Articles

Implications of ERC Research To gauge market response to information Separate persistent and non persistent information Extraordinary items Disclosing information about securities- leveraging affect- should go with last slide?? - Separate the persistent information to increase reliability of firms future performance Market Research Brown and Ball Earning Response Best Policy Articles

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

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

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

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

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

Value creation in the biotechnology industry Bruce McConomy; Bixia Xu

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

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

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

The Biotech Value Chain 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 Supporting Activities: Intellectual Property Protection (Legal) Information Systems Facilities (Contract Research Organization) Strategy Procurement (Contract Manufacturers) Financing Human Resources Management Investor Relations

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

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

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

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 The typical disclosure decision model assumes that managers will have to make the decision whether to disclose successes and failures in the different product phases to the public Disclosure of the signal affects investors Market Research Brown and Ball Earning Response Best Policy Articles

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? Costly Uncertainty in profits because a failure at any level will completely shut down the project The biotech industry is fiercely competitive and disclosure costs are generally high because most companies develop only a few products, and the entrance of a competitor poses a serious survival threat If a competitor is able to observe that a clinical trial was a success, they are likely to piggy-back off of this and create substitute drugs Market Research Brown and Ball Earning Response Best Policy Articles

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 The biotechnical industry is complex, and its profits are generally earned at the end of a long and tedious research cycle Market Research Brown and Ball Earning Response Best Policy Articles

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? The first article we will cover discuses if environmental disclosure matters? This article brings up significant debate from three points of views in terms of whether the information required to be disclosed should be self regulated by companies or should be regulated by standards. In order to ensure that it is consist across all businesses. In the first stance, surveys have shown that if standards are enacted based on the required environmental disclosure, the result will be an increased quality in information. It argues that: Corporate environmental reporting is far from standard and it seems many firms don’t take advantage of it as a value creation tool. The article specifically sites the CICA handbook section 3061, which addresses the disclosure of any environmental liabilities that are present. It states that this resulted in a higher quality of information provided by management. This article then goes on to discuss how the disclosure of environmental issues may affect the stakeholder’s opinions and whether this increased information will result in a benefit to society as a whole. The amount of environmental information that is currently provided by companies is affected by several factors. Firms with low financial leverage do release potentially damaging, but credible, environmental information that will hopefully enhance their reputation as a quality disclosure. This is because more shareholders’ increases the need for more disclosure in annual reports. On the other hand less users equals less need for disclosure because this information would already be known because they work within the firm. Another example is that, a larger firm may be more apt to disclosure their environmental state because lobby groups will target them over smaller companies. It is advantageous for a company to disclosure information now versus hiding information and getting caught. However, in Canada there is not large pressure from media and environmental groups to disclose environmental information. Therefore the disclosure of information in Canada is largely driven by what has been disclosed in the past. This results in the same basic information being presented from year to year. This brings up the question as the whether the information currently being presented is relevant to society? In addition, It presents the question as to whether this information is being used by the stakeholders to value the firm? Market Research Brown and Ball Earning Response Best Policy Articles

Points of View Manager Standard Setters Shareholders 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? The example presented in the article cited the adoption of section 3060, which requires the disclosure of environmental liabilities. While evidence suggested that the disclosure was of use to the investors, managers did not adopt the liabilities until it was required to. This brings on the viewpoint that managers will not disclosure information that may negatively affect their value. Therefore, based on the three points of view: is environmental disclosure standards required? What are your goals for Financial Statements? Do you think that this creates reliable and relevant information for society?

Conclusion Managers Standard Setters Stakeholders Advantages of Disclosure Can bring a lower cost of capital Enhance interest by Institutional Investors Increased Transparency Consistency Across Companies Integration into financial reporting Provides credible information Keeps companies held responsible Reduces potential risk Disadvantages of Disclosure Costly Will hurt the reputation of the company Risk of credibility with partial disclosure Can be costly to society Must balance the cost versus benefit While, a manager can see the potential advantages of providing environmental disclosure, such as a lower cost of capital because it is seen as more transparent by the shareholders. There is significant risk with having to disclose. The first of which is the idea that if stakeholders believe that the company is fabricating the information to present the best image of the company. There may be a decreased trust in the information. In order to not present this view the company may need to be more critical of the companies environmental stance. This may backfire on the company because they are providing damaging information about the company to the competition to exploit. This could then be used to paint the company as a poor partner in business with suppliers, customers, and other stakeholders. As a result, it is a very risky subject for a company to address because too much or too little information can severely affect the company.

Recommendation Expanded management discussion and environmental analysis A revision of reporting under some uncertainty Increased Auditor consideration of environmental risk The portion devoted to the management discussion and analysis of environmental issues should be expanded A revision of accounting recognition and measurement in order to restrict the freedom of management and auditors to refrain from reporting environmental liabilities due to the uncertainty about their magnitude Tighten auditing standard in order to increase auditor consideration of environmental risks, the sources of these risks and the consequences of these risks from the perspective of the readers of financial statements IFRS has presented a more detailed and precise definition of the accounting for an environmental liability. Previously under GAAP a liability was recorded when it was a legal, equitable or constructive obligation and is only recorded when it is likely to occur. While IFRS states that a liability exists when there is a present obligation resulting from a past event, it is more likely than not and can reasonably be estimated. In addition, It states that a constructive obligation exists when past practice has shown that the company will accept certain responsibly. Under IFRS a liability must be recorded at the midrange of possible estimates to create the most accurate number, while GAAP allows you to disclose the lower end of the range. Under IFRS the note disclosure requirements is significantly expanded compared to GAAP. Specifically, you must disclose all amounts including, new provisions, payments, and revisions. In addition, they must disclose a brief description of the event and any uncertainties related. Market Research Brown and Ball Earning Response Best Policy Articles

Questions?