Chapter 5: The Information Approach to Decision Making

1. Chapter 5: The Information Approach to Decision Making

2. Overview • This chapter answers the question: • Do security market prices respond to accounting information? • A number of studies were completed to answer this question • Ball and Brown study from 1968

3. Overview Cont’d • The information approach is the equating of usefulness to information content • Investors want to make their own predictions rather than have accountants do it for them • Information is useful if it leads investors to change their beliefs and actions • The degree of usefulness can be measured by the extent of volume or price change following the release of information

4. Does Disclosure Matter • Does releasing lots of information help stakeholders make more informed decisions and help to better gage the value of the firm? Or is it viewed as unreliable since management is producing the data? • Are there dangers of disclosure?

5. Decision Making • Deals with regulation standards on environmental disclosure • Most owners use information about environmental disclosures to make decisions • The media plays a critical role to convey non-financial information

6. Amount of Disclosure • Convergence within industries to disclose certain trends • Canada faces less impact than other countries such as Germany and France • What is the ideal level of disclosure?

7. Reasons for Market Response Consider the following predictions about investor behaviour in response to financial statement information: 1. Investors have prior beliefs about a firm’s future performance

8. Reasons for Market Response Cont’d 2. When the current period’s net income is released, some investors will decide to become more informed by analyzing the income number 3. Investors who have revised their beliefs about future firm performance upwards, will buy the firm’s shares at their current market price 4. Expect to observe the volume of shares traded to increase when the firm reports its net income

9. Reasons for Market Response Cont’d • A study was completedby Beaver, Clarke and Wrightwhich examinedtrading volume reaction • Found a dramatic increase in tradingvolume during the week that earnings announcements were released

10. Finding the Market Response • Efficient markets theory implies that the market will react quickly to new information • The good or bad news in reported net income is evaluated relative to what investors expected • There arealways many events taking place that affect a firm’s share volume and price

11. Separating Market-Wide and Firm-Specific Factors Equation of the market model: • Rjt= αj + βJRMt+εjt • Rjt= Return on firm j’s shares for period t • RMt= Return on market portfolio for period t • εjt= firm specific return on j’s shares

12. Separating Market-Wide and Firm-Specific Factors Cont’d • Ror this equation researchers obtain past data on Rjt and RMt • Then use regression analysis to estimate the coefficients of the model • For example suppose: • αj = 0.0001 • βJ = 0.80

13. Separating Market-Wide and Firm-Specific Factors Cont’d • The researcher must now consult the financial media to identifythe day of the firm’s current earnings announcement • Call this day “0” • Suppose for thisday the return on the Dow Jones Industrial Index was 0.001

14. Separating Market-Wide and Firm-Specific Factors Cont’d • Nextthe estimated market model for firm j is used to predict the return on firm j’s shares for that day • Expected return = 0.0001 + (0.80 x 0.001) = 0.0009

15. Separating Market-Wide and Firm-Specific Factors Cont’d • Assume the actual return on firm j’s shares for day 0 is 0.0015 • The difference between actual and expected is 0.0006 (εjt ) • This number is an estimate of the abnormal, or firm-specific, return on firm j’s shares for that day

16. Separating Market-Wide and Firm-Specific Factors Cont’d • Graphical illustration of the market model for firm j for period t

17. Comparing Returns and Income • We can now compare the abnormal share return on day 0 as calculated above with the unexpected component of the firm’s current reported net income • If this unexpected net income is good news, then given securities market efficiency, a positive abnormal share return gives evidence that investors,on average,are reacting favourably to the unexpected good news in earnings

18. Comparing Returns and Income Cont’d Difficulties with the methodology: • Other firm-specific information is frequentlyreleasedaround the time asa firm’s earnings announcement • The firm’s beta is an estimation

19. Ball and Brown Study Cont. • Ball and Brown conducted the study in 1968 • The study was conducted on a sample of 261 NYSE firms in attempt to determine market price response to earnings information

20. Ball and Brown Study • http://www.youtube.com/watch?v=_QDBX9KfxHM&feature=relmfu

21. B&B - Methodology • They determined abnormal return over expected return and compared it to good income performance (GN) or bad income performance (BN) via a performance proxy i.e. last year’s earnings compared to this year’s earnings • Observed results over a narrow window of one month and a wide window of 18 months

22. B&B - Results • Both narrow and wide windows related good news to positive returns and bad news to negative returns • Noticed that when using the wide window, the price of shares with positive income news were already increasing prior to GN release • Study suggests that 85-90% of information was already built into price by the time earnings were announced

23. B&B - Results

24. B&B - Outcomes • Since both wide and narrow windows related good news with positive price changes and vice versa with bad news we can conclude that income news is only correlated with price change, it does not cause the change • Beaver, Clarke and Wright in 1979 extended the study to examine the effects of the magnitude of unexpected earnings and concluded that greater unexpected earnings were correlated with greater market response

25. Earnings ResponseCoefficients • From the BB study we can see that on average good news (“GN”) firms enjoyed abnormal returns and that bad news (“BN”) firms showed negative returns • Why does the market respond more strongly to good or bad news in earningsreports for some firms than for others? • With the answer to this, accountants can improve their understanding of how information is useful to investors and in turn prepare more useful financial statements

26. Earnings Response Coefficients Cont’d • Earnings Response Coefficient – measures the extent of a security’s abnormal market return in response to the unexpected component of reported earnings of the firm issuing that security • ERC = Abnormal Share Return / Unexpected Earnings for Period • Measures abnormal return per dollar of abnormal earnings

27. Reasons for Differential Market Response • Beta • Capital Structure • Earnings Quality • Growth Opportunities • The Similarity of Investor Expectations • The Informativeness of Price

28. Beta • Recall: Beta measures the co-movement between changes in the price of a security and changes in the market value of the market portfolio • The riskier future returns are the lower investors’ reactions to a given amount of unexpected earnings will be • Higher beta securities generally have lower ERC’s

29. Capital Structure • Increases in earnings add strength and safety to bonds and other outstanding debt so much of the GN in earnings goes to the debt holders • Highlylevered firms generally have lower ERC’s

30. Earnings Quality • Recall:Quality of earnings is defined by the magnitude of the diagonal probabilities of the associated information system • Thus the higher the probabilities are the higher theERC will be because investors are better able to infer future firm performance from today's performance • Problem: information system probabilities are not directly observable • Solution: Infer earnings quality by the magnitude of analysts' earnings forecast revision announcement

31. Earnings Quality Cont’d • Why do analysts adjust estimates more for some firms than others? • Earnings persistance • Permanent, expected to persist indefinately • Transitory, affecting earnings in current year but not future years • Price irrelevant, persistence of zero • In effect there are three ERC's each of which could be present in the same income statement • Investors should attempt to identify the different types separately and assign different ERC's to each rather than trying to estimate an average

32. Earnings Persistence Example Assess the earnings persistence for the following events (Permanent, Transitory or Price irrelevant): 1. Unanticipated gain from disposal of equipment 2. A new technology is developed which is expected to increase profits by 5% in perpetuity 3. The firm capitalizes a lot of organization costs

33. Earnings Persistence Example Assess the earnings persistence for the following events (Permanent, Transitory or Price irrelevant): 1. Unanticipated gain from disposal of equipment - Transitory 2. A new technology is developed which is expected to increase profits by 5% in perpetuity - Permanent 3. The firm capitalizes a lot of organization costs - Price irrelevant - assuming organizational costs have no salvage value

34. Earnings Quality Cont’d • Second dimension of earnings quality is accruals quality • Net Income = Cash Flow from Operations +/- Net Accruals • Accruals include changes in non-cash working capital accounts (AR, AFDA, AP, inventories etc.) • High quality - accruals show up as cash flow the next period • Ex. If AR is $1,000 and AFDA is $100 and $900 is collected the next period, the accruals are considered high quality

35. Testing Accrual Quality • DeChow and Dichev ΔWCt = b0 + b1 CFOt-1 + b2CFOt + b3 CFOt+1 + Et Δ WC = change in net non-cash working capitalt = periodCFO = cash flow from operations in period tb = constants that are to be estimatedE = residual error term (portion of total accruals not explained by cash from operations)

36. Testing Accrual Quality Cont’d ΔWCt = b0 + b1 CFOt-1 + b2CFOt + b3 CFOt+1 + Et • Data is used from several periods • High E indicates a poor match between current accruals and subsequent actual operating cash flow realizations • ERC and share price respond positively to accrual quality

37. Growth Opportunities • GN or BN may suggest future growth opportunities and hence a higher ERC • Ex. Recent projects display unexpected high profitability • To assess growth often P/E shops and portfolio managers analyze the ratio of market value of equity / book value of equity • The market will be aware of growth opportunities before they are recognized in income thus driving the stock price up

38. Growth Opportunities Cont’d To better understand analyze a simple perpetuity: • Calculate the present value of a 10 % perpetuity:1/10% = $10 • Now assume the same perpetuity will grow by 5% per year: 1/(10%-5%) = $20 Clearly the value increases when growth opportunities are introduced

39. Similarities of Investor Expectation • Each investor will have a different expectations based on the amount of available information to them and their abilities to comprehend it • However these differences are reduced since many investors draw their information from similar sources – analyst consensus forecasts etc. • Depending on expectations they will interpret earnings news as GN or BN but since most expectations are similar they will generally have the same interpretation of the news • The more similar the expectations are the greater the effect will be on the ERC

40. The Informativeness of Price • Market price itself is partially informative about the future value of the firm (leads) • Market price includes all publicly known information about the firm • A more informative share price implies the market anticipates changes in earnings power sooner • The more informative the price the less informative earnings releases will be and hence the firm will have a lower ERC

41. Reasons for Differential Market Response • An increase in the following factors will lead to:

42. Questions Assess the impact on the firm’s ERC: • A firm’s beta increases from 1 to 2.3 • A firm pays off 20% of their debt • The firms quality of earnings falls • The return on recent projects that the firm has been taking on have been experiencing lower than historical projects

43. Questions Cont’d Assess the impact on the firm’s ERC: 5. Investors expectations become more similar 6. Due to improved news coverage the price becomes more informed

44. Implications of ERC Research • Improved understanding of market responses allows accountants to create and provide more useful information to investors • Capital structure – highly levered firms should have lots of detail disclosing the nature and extent of all liabilities • Growth – the MD&A enables management to communicate growth prospects • Components of net income areimportant because theyallows investors to betterinterpret the earnings number

45. Implications of ERC Research Cont’d • IAS 1 prohibits the use of extraordinary items in theincome statement and requires separate disclosure in the notes for: • Material write-downs and reversals thereof • Restructuring provisions • Gains and losses on provisions • Other low-persistent items • This puts considerable onus on the accountant to fully disclose details of unusual, non-recurring and extraordinary items

46. Measuring Investors’ Earnings Expectations • Must obtain a reasonable proxy for expected earnings because the market will only react to the component of net income they did not expect • When conditions are not ideal earnings expectations are more complex • Ways to deal with this complexity: • Time Series approach • Analysts’ forecasts

47. Time Series Approach • Analyze the persistence of past earnings to forecast future earnings • The two extremes of earnings persistence: • Completely persistent – expected earnings for current year are last year’s actual earnings and estimated as the change from last year • Zero persistence – no information from last year is used and all earnings this year are unexpected

48. Analyst forecasts • More accurate than time series forecasts • Analysts interpret more information than past earnings • The age of a forecast has an important fact on its accuracy • The most recent earnings forecast provided a more accurate earnings production than the average forecast of all analysts following the firm (ignoring how old the individual forecasts were) • Timeliness dominates the cancelling-out-of-errors effect of the average forecast

49. Summary • The market is on average very sophisticated in its ability to evaluate accounting information • This supports the theory of securities market efficiency and supports the decision usefulness approach to financial reporting • As accountants better understand investor response they will be able to provide more useful information to investors

50. The “Best” Accounting Policy • Need to be careful to not only consider the market • Accounting information is a public good • Accounting information should benefit society overall