1. Copyright © 2009 by Pearson Education Canada 5 - 1 Chapter 5 The Information Approach to Decision Usefulness

2. Copyright © 2009 by Pearson Education Canada 5 - 2 Capital Market-driven Earnings Management

3. Copyright © 2009 by Pearson Education Canada 5 - 3 Outlines Information Approach The Research Problem The Ball and Brown Study Earnings Response Coefficients Unusual, Non-Recurring, and Extraordinary Items A Caveat about the “Best” Accounting Policy The information content of Other Financial Statement Information

4. Copyright © 2009 by Pearson Education Canada 5 - 4 Chapter 5 The Information Approach to Decision Usefulness

5. Copyright © 2009 by Pearson Education Canada 5 - 5 The Information Approach Assumes securities market efficiency Investors responsible for predicting future firm performance –Role of financial reporting to provide useful information for this purpose Usefulness of financial information evaluated by magnitude of security price response to that information This equating of usefulness to information content is called the information perspective on decision usefulness of financial reporting

6. Copyright © 2009 by Pearson Education Canada 5 - 6 5.2.1 Reasons for Security Price Response An application of decision theory model –Investors have prior probabilities of future firm performance –Investors obtain useful information from financial statements –Investors revise their probabilities –Leads to buy/sell decisions –Security price changes –Return on share changes

7. Copyright © 2009 by Pearson Education Canada 5 - 7 Abnormal Share Return Total share return = return due to market-wide factors ± abnormal share return due to firm-specific factors –Only abnormal share return can be attributed to financial accounting information –If good news in financial statements leads to positive abnormal share return (and vice versa), conclude financial statement information is useful. –To reach such a conclusion, need to separate market-wide and firm-specific returns

8. Copyright © 2009 by Pearson Education Canada 5 - 8 5.2.3 Separating Market-Wide and Firm- Specific Factors Firm releases financial information –Most studies look at release of earnings Use market model to estimate market-wide return on that day (or narrow window) –Assumes market efficiency Abnormal share return during narrow window = total return – market-wide return »Continued

9. Copyright © 2009 by Pearson Education Canada 5 - 9 Market-wide and Specific Factors, Cont’d We can also use CAPM to separate expected and unexpected –R jt = R f (1 -β j ) + β j (Rmt) + ε jt The first two terms are the expected rate and the last one the unexpected (Epsilon, represents the abnormal return) We will calculate our expected and unexpected returns. See Figure 5.2 for details »Continued

10. Copyright © 2009 by Pearson Education Canada 5 - 10 5.2.3 Separating Market-Wide and Firm- Specific Factors (continued)

11. Copyright © 2009 by Pearson Education Canada 5 - 11 Unexpected Earnings Investors have expectations of current earnings Investors’ expectations are built into share price prior to release of current earnings –Assumes market efficiency Investors will react only to unexpected earnings Investors’ earnings expectations unobservable –How to separate expected and unexpected earnings?

12. Copyright © 2009 by Pearson Education Canada 5 - 12 Estimation of Investors’ Earnings Expectations Time series approach –Based on earnings in prior years Analysts’ forecasts –Available for most large firms –Now the most common approach

13. Copyright © 2009 by Pearson Education Canada 5 - 13 5.3 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

14. Copyright © 2009 by Pearson Education Canada 5 - 14 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 »Continued

15. Copyright © 2009 by Pearson Education Canada 5 - 15 B&B Methodology (continued) 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, next slide

16. Copyright © 2009 by Pearson Education Canada 5 - 16 B&B Results

17. Copyright © 2009 by Pearson Education Canada 5 - 17 B&B 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

18. Copyright © 2009 by Pearson Education Canada 5 - 18 5.3.2 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 Narrow window studies more consistent with decision usefulness

19. Copyright © 2009 by Pearson Education Canada 5 - 19 5.3.3 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 On Other Stock Markets? Yes Response to Balance Sheet Information? Hard to Find

20. Copyright © 2009 by Pearson Education Canada 5 - 20 5.4 A Different Question Earnings Response Coefficients (ERC) –Do characteristics of unexpected earnings affect magnitude of abnormal share return? Yes

21. Copyright © 2009 by Pearson Education Canada 5 - 21 5.4.1 Factors Affecting ERC Risk (ß): higher ß  lower ERC Capital structure: higher D/E  lower ERC Earnings quality: higher quality  higher ERC –Earnings persistence: higher persistence  higher ERC »Continued

22. Copyright © 2009 by Pearson Education Canada 5 - 22 5.4.1 Factors Affecting ERC (continued) Growth opportunities: higher opportunities, higher ERC Similarity of investor expectations: more similar, higher ERC Informativeness of price: more informative, lower ERC?

23. Copyright © 2009 by Pearson Education Canada 5 - 23 More On Earnings Quality How to Measure? –Conceptual: main diag. probs. of info. system –Earnings persistence: higher persistence → higher quality Line-by-line evaluation (Ramakrishnan & Thomas (1991)) –Accruals quality (DeChow & Dichev (2002)): higher accruals quality → higher earnings quality NI= CFO + Net Accruals

24. Copyright © 2009 by Pearson Education Canada 5 - 24 Cisco Systems, Inc. NASDAQ

25. Copyright © 2009 by Pearson Education Canada 5 - 25 5.4.2 Implications of ERC Research Lower informativeness of Price for smaller firms The ERCs are lower for highly levered firms MD&A enables the firm to communicate its growth prospects The importance of earnings persistence to the ERC means that disclosure of the components of net income is useful for investors

26. Copyright © 2009 by Pearson Education Canada 5 - 26 5.5 Unusual, Non-Recurring, and Extraordinary Items 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 »Continued

27. Copyright © 2009 by Pearson Education Canada 5 - 27 5.5 Unusual, Non-Recurring, and Extraordinary Items (continued) Definition of extraordinary item –Infrequent they are not expected to occur frequently over several years –Not typical they do not typify the normal business activities of the entity –Do not depend primarily on decisions of managers or owners If item is not extraordinary, it is part of operating income

28. Copyright © 2009 by Pearson Education Canada 5 - 28 A Financial Reporting Problem Manager motivation to put core earnings “in the bank” by overstating unusual, non-recurring, and extraordinary writeoffs Overstating writeoffs overstates future core earnings –Effect is to overstate earnings persistence, thereby misleading investors –See Theory in Practice 11.1 re: Nortel

29. Copyright © 2009 by Pearson Education Canada 5 - 29 5.6 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 Thus firm cannot charge users for accounting information »Continued

30. Copyright © 2009 by Pearson Education Canada 5 - 30 5.6 Accounting Information as a Public Good (continued) Investors who do not pay for accounting information will demand more of it than socially desirable Implication is that standard setters cannot be sure that an accounting policy that has a higher ERC than another is socially better. Complicates standard setting Still true, though, that an accounting policy with higher ERC is more useful to investors

31. Copyright © 2009 by Pearson Education Canada 5 - 31 5.7 The information content of Other Financial Statement Information Magliolo(1986) –RRA does not measure the market values of oil and gas reserves as theory would predict Doran, Collins,and Dhalival(1988) –DCD’s results provide, at best, fairly weak evidence in favour of RRA Harris and Ohlson (1987) –RRA information also had some explanatory power, but less than historical cost Ghicas and Pastena(1989) –When recent analyst information was available any ability that RRA had to explain oil company value disappeared

32. Copyright © 2009 by Pearson Education Canada 5 - 32 5.8 Conclusion Security market response to accounting information supports rational decision theory and efficient securities market theory

33. The End Thank you