financial accounting theory craig deegan chapter 10

Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan 10.1

Financial Accounting TheoryFinancial Accounting TheoryCraig DeeganCraig Deegan

Chapter 10Chapter 10

Reactions of capital markets to financial Reactions of capital markets to financial reportingreporting

Slides written by Michaela RankinSlides written by Michaela Rankin

Chapter 10: Capital markets reactions


Learning ObjectivesLearning Objectives

• In this chapter you will be introduced to In this chapter you will be introduced to – the role of capital market research in assessing the role of capital market research in assessing

the information content of accounting the information content of accounting disclosuresdisclosures

– the assumptions of market efficiency adopted the assumptions of market efficiency adopted in capital market researchin capital market research



Learning ObjectivesLearning Objectives

– the difference between capital market research the difference between capital market research that looks at the information content of accounting that looks at the information content of accounting disclosures, and capital market research that uses disclosures, and capital market research that uses share price data as a benchmark for evaluating share price data as a benchmark for evaluating accounting disclosuresaccounting disclosures

– why unexpected accounting earnings and why unexpected accounting earnings and abnormal share price returns are expected to be abnormal share price returns are expected to be relatedrelated

– the major results of capital market research into the major results of capital market research into financial accounting and disclosure financial accounting and disclosure



Capital market research— Capital market research— introductionintroduction

• Explores the role of accounting and other Explores the role of accounting and other financial information in equity marketsfinancial information in equity markets

• involves examining statistical relations involves examining statistical relations between financial information and share between financial information and share pricesprices

• reactions of investors evident from capital reactions of investors evident from capital market transactionsmarket transactions

• no share price change implies no reactionno share price change implies no reaction



Capital market versus Capital market versus behavioural researchbehavioural research

• capital market research: capital market research: – assesses the assesses the aggregateaggregate effect of financial effect of financial

reporting on investorsreporting on investors– considers only investorsconsiders only investors

• Behavioural research: Behavioural research: – analyses analyses individualindividual responses to financial responses to financial

reporting reporting – examines decision-making by many groupsexamines decision-making by many groups

• eg. bank managers, loan officers, auditorseg. bank managers, loan officers, auditors



Reasons for capital market Reasons for capital market researchresearch

• Information about earnings and its Information about earnings and its components is the primary purpose of components is the primary purpose of financial reportingfinancial reporting

• earnings are oriented towards the interests of earnings are oriented towards the interests of shareholdersshareholders

• earnings is the number most analysed and earnings is the number most analysed and forecast by security analystsforecast by security analysts

• reliable data on earnings is readily available reliable data on earnings is readily available



Underlying assumption of Underlying assumption of CMR—EMHCMR—EMH

• CMR relies on the assumption that equity CMR relies on the assumption that equity markets are efficientmarkets are efficient– in accordance with Efficient Market Hypothesisin accordance with Efficient Market Hypothesis

• efficient market defined as a market that efficient market defined as a market that adjusts rapidly to fully impound adjusts rapidly to fully impound information into share prices when the information into share prices when the information is releasedinformation is released



Three forms of Market Three forms of Market EfficiencyEfficiency

• Weak formWeak form: prices reflect information about : prices reflect information about past prices and trading volumespast prices and trading volumes

• Semi-strong form:Semi-strong form: all publicly available all publicly available information is rapidly and fully impounded information is rapidly and fully impounded into share prices in an unbiased manner into share prices in an unbiased manner when releasedwhen released– most relevant for accounting-based capital most relevant for accounting-based capital

market researchmarket research• strong formstrong form: security prices reflect all : security prices reflect all

information (public and private)information (public and private)



Market efficiencyMarket efficiency —implications for accounting —implications for accounting

• If markets are efficient they will use If markets are efficient they will use information from various sources when information from various sources when predicting future earnings predicting future earnings

• if accounting information does not impact if accounting information does not impact on share prices then it is deemed not to have on share prices then it is deemed not to have any information value above that currently any information value above that currently availableavailable



Earnings/return relationEarnings/return relation

• Share prices are the sum of expected future Share prices are the sum of expected future cash flows from dividends, discounted to cash flows from dividends, discounted to their present value using a rate of return their present value using a rate of return commensurate with the company’s riskcommensurate with the company’s risk

• dividends are a function of accounting dividends are a function of accounting earningsearnings

• unexpected earnings rather than total unexpected earnings rather than total earnings expected to be associated with a earnings expected to be associated with a change in share price change in share price



Earnings/return relation—Earnings/return relation—market modelmarket model

• Used to separate out firm-specific share Used to separate out firm-specific share price movements from market-wide price movements from market-wide movementsmovements– derived from the Capital Asset Pricing Modelderived from the Capital Asset Pricing Model

• assumes investors are risk averse and have assumes investors are risk averse and have homogeneous expectationshomogeneous expectations

• its use allows the researcher to focus on its use allows the researcher to focus on share price movements due to firm-specific share price movements due to firm-specific newsnews



Earnings/return relation— Earnings/return relation— continuedcontinued

• Total or actual returns can be divided into:Total or actual returns can be divided into:– normal (expected) returns given market-wide normal (expected) returns given market-wide

movementsmovements– abnormal (unexpected) returns due to firm-abnormal (unexpected) returns due to firm-

specific share price movementsspecific share price movements

• abnormal returns used as an indicator of abnormal returns used as an indicator of information content of announcementsinformation content of announcements



Results of CMR—Ball and Results of CMR—Ball and Brown (1968) studyBrown (1968) study

• examined data from 261 US firmsexamined data from 261 US firms

• tested whether firms with unexpected tested whether firms with unexpected increases in accounting earnings had increases in accounting earnings had positive abnormal returns, and firms with positive abnormal returns, and firms with unexpected decreases had negative unexpected decreases had negative abnormal returnsabnormal returns



Results of CMR—Ball and Results of CMR—Ball and Brown (1968) study—continuedBrown (1968) study—continued

• Found:Found:– information contained in the annual report, information contained in the annual report,

prepared using historical cost was useful to prepared using historical cost was useful to investorsinvestors

– 85-90% of earnings announcement is 85-90% of earnings announcement is anticipated by investors anticipated by investors

– much of information is obtained from other much of information is obtained from other sourcessources



Results of CMR—extent of Results of CMR—extent of alternative information sourcesalternative information sources

• Information content varies between countries Information content varies between countries and companiesand companies

• compared to US markets, Australian market compared to US markets, Australian market had slower adjustments during the year with had slower adjustments during the year with larger adjustments at earnings announcementlarger adjustments at earnings announcement– less alternative sources of information for less alternative sources of information for

Australian marketAustralian market• less alternative sources of information for less alternative sources of information for

smaller firms than larger firmssmaller firms than larger firms



Results of CMR—permanent Results of CMR—permanent and temporary changesand temporary changes

• Research examined relation between the Research examined relation between the magnitude of unexpected changes in magnitude of unexpected changes in earnings (EPS) and magnitude of abnormal earnings (EPS) and magnitude of abnormal returnsreturns– known as the earnings response coefficientknown as the earnings response coefficient– a 1% unexpected change in earnings associated a 1% unexpected change in earnings associated

with 0.1 to 0.15% abnormal returnwith 0.1 to 0.15% abnormal return– depends on whether earnings increases depends on whether earnings increases

expected to be permanent or temporary expected to be permanent or temporary



Results of CMR—relative Results of CMR—relative magnitudes of cash and accrualsmagnitudes of cash and accruals

• Earnings persistence depends on proportion Earnings persistence depends on proportion of accruals relative to cash flowsof accruals relative to cash flows– firms with large accruals relative to actual cash firms with large accruals relative to actual cash

flows unlikely to have persistently high flows unlikely to have persistently high earningsearnings

• share prices found to act as if investors share prices found to act as if investors ‘fixate’ on reported earnings without ‘fixate’ on reported earnings without considering relative magnitudes of cash and considering relative magnitudes of cash and accrual components accrual components



Results of CMR—information Results of CMR—information announcements of other firmsannouncements of other firms

• Earnings announcements by one firm also Earnings announcements by one firm also results in abnormal returns to other firms in results in abnormal returns to other firms in the same industrythe same industry

• related to whether the news reflects a related to whether the news reflects a change in conditions for the entire industry, change in conditions for the entire industry, or changes in relative market share within or changes in relative market share within the industrythe industry



Results of CMR—information Results of CMR—information content of earnings forecastscontent of earnings forecasts

• Announcements of Announcements of expectedexpected earnings rather earnings rather than than actualactual earnings are associated with earnings are associated with share returnsshare returns

• management and security analysts both management and security analysts both make forecastsmake forecasts



Results of CMR—benefits of Results of CMR—benefits of voluntary disclosurevoluntary disclosure

• Voluntary disclosures include those in Voluntary disclosures include those in annual reports as well as media releases etc.annual reports as well as media releases etc.

• firms with more disclosure policies have:firms with more disclosure policies have:– larger analyst following and more accurate larger analyst following and more accurate

analyst earnings forecastsanalyst earnings forecasts– increased investor following increased investor following – reduced information asymmetryreduced information asymmetry– reduced costs of equity capitalreduced costs of equity capital



Results of CMR—recognition Results of CMR—recognition versus footnote disclosureversus footnote disclosure

• Recognising an item in the financial Recognising an item in the financial statements is perceived differently to statements is perceived differently to disclosure in footnotesdisclosure in footnotes

• investors place greater reliance on investors place greater reliance on recognised amounts than on disclosed recognised amounts than on disclosed amountsamounts



Results of CMR—sizeResults of CMR—size

• Relationship between earnings Relationship between earnings announcements and share price movements announcements and share price movements is inversely related to the size of the entityis inversely related to the size of the entity

• earnings announcements found to have a earnings announcements found to have a greater impact on share prices of smaller greater impact on share prices of smaller firms than larger firmsfirms than larger firms

• more information generally available for more information generally available for larger firmslarger firms



Do current prices anticipate Do current prices anticipate future announcements? future announcements?

• As firm size increases, share prices As firm size increases, share prices incorporate information from wider number incorporate information from wider number of sourcesof sources– relatively less unexpected information when relatively less unexpected information when

earnings are announcedearnings are announced

• may be able to argue that share prices may be able to argue that share prices anticipate future earnings announcements anticipate future earnings announcements for larger firms with some accuracyfor larger firms with some accuracy



Accounting earnings Accounting earnings reflecting information reflecting information

• Rather than determining whether earnings Rather than determining whether earnings announcements announcements provideprovide information, recent information, recent research examines whether earnings research examines whether earnings announcements announcements reflectreflect information that has information that has been already used by investorsbeen already used by investors– ‘‘looking back the other way’looking back the other way’– market prices viewed as leading accounting market prices viewed as leading accounting

earnings earnings



Accounting earnings reflecting Accounting earnings reflecting information—continuedinformation—continued

• Share prices are considered as benchmark Share prices are considered as benchmark measures of firm valuemeasures of firm value

• share returns are considered as benchmark share returns are considered as benchmark measures of firm performancemeasures of firm performance

• benchmarks are then used to compare benchmarks are then used to compare usefulness of alternative accounting and usefulness of alternative accounting and disclosure methodsdisclosure methods

• based on premise that market values and based on premise that market values and book values are both measures of firm valuebook values are both measures of firm value



Accounting earnings reflecting Accounting earnings reflecting information—continuedinformation—continued

• If market value is related to book value, If market value is related to book value, returns should be related to accounting returns should be related to accounting earnings per share, divided by price at the earnings per share, divided by price at the beginning of the accounting periodbeginning of the accounting period– provides an underlying reason why we should provides an underlying reason why we should

expect returns to be related to earnings over expect returns to be related to earnings over timetime



Results of CMR—Accounting Results of CMR—Accounting earnings reflecting information earnings reflecting information

• Beaver, Lambert and Morse (1980) found Beaver, Lambert and Morse (1980) found share prices and related returns were related share prices and related returns were related to accounting earningsto accounting earnings

• because of various information sources, because of various information sources, price appeared to anticipate future price appeared to anticipate future accounting earningsaccounting earnings

• supported by Beaver, Lambert and Ryan supported by Beaver, Lambert and Ryan (1987)(1987)



Results of CMR—Earnings Results of CMR—Earnings reflecting information cont.reflecting information cont.

• Collins, Kothari and Rayburn (1987) found Collins, Kothari and Rayburn (1987) found evidence that share prices was a better evidence that share prices was a better indicator of future earnings in larger firms indicator of future earnings in larger firms than smaller firmsthan smaller firms

• Dechow (1994) found over short intervals Dechow (1994) found over short intervals earnings are more strongly associated with earnings are more strongly associated with returns than are realised cash flowsreturns than are realised cash flows– the ability of cash flows to measure firm the ability of cash flows to measure firm

performance increases as the measurement performance increases as the measurement interval increases interval increases



Results of CMR—Earnings Results of CMR—Earnings reflecting information cont.reflecting information cont.

• Studies examining which asset value Studies examining which asset value approaches provide accounting figures that approaches provide accounting figures that best reflect market valuation found:best reflect market valuation found:– fair value estimates of bank’s financial fair value estimates of bank’s financial

instruments seem to provide a better instruments seem to provide a better explanation of bank share prices than historical explanation of bank share prices than historical cost (Barth, Beaver and Landsman 1996)cost (Barth, Beaver and Landsman 1996)

– revaluation of assets results in better alignment revaluation of assets results in better alignment of market and book values (Easton, Eddy and of market and book values (Easton, Eddy and Harris 1993) Harris 1993)

financial accounting theory craig deegan chapter 10

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