M1: Accounting Information in Capital Markets

Transcription

1 M1: Accounting Information in Capital Markets 1. Introduction We want to explain & predict accounting practice. We will examine 2 economic theories in detail: - Information theory; and - Agency theory 2. Information Theory Objectives - discuss: - Importance of accounting numbers; - Research; - Regulatory implications. Information Theory Tells us whether it provides useful information to users to help them make business decisions on whether to invest or not. The earnings numbers also provide important information. Agency Theory, on the other hand, provides incentives for firms to use accounting policies to account for the firm s transactions. E.g. straight line v/s reducing balance, and we want to understand why they ve made certain choices. 3. What is Information Theory? It addresses the usefulness of (accounting) information in investment decisions, and tries to understand practices used by firms. Researchers will try to determine why straight line is being used, they don t tell you what you should do. - History Dissatisfaction with prescriptive theories of accounting (although the evidence was contrary to the general perspective/dissatisfaction). Prescriptive theories tell us how firms ought to be, or what they should do. There was dissatisfaction was because they seemed to be incapable of explaining what firms were actually doing with regards to their accounting. E.g. a prescriptive theory says that the firm should use a reducing balance method for depreciation, but firms are using straight line, the theory doesn t explain why the other firms aren t using reducing balance method.; This lead to rise of empirical research in 1950s & 1960s investigating the following research question: Is accounting information useful to investors? Yes. 4. Ball & Brown (1968) Study 4.1 Overview of the study - Ball and Brown (1968) (B&B) examine the relation between earnings & share prices. Earnings are accounting information; is this related to the share price of the firm? - Assumptions - Investors: 1. Find future EPS relevant for making decisions (provides information about the company s future cash flows);

2 2. Can forecast Earnings Per Share (EPS) from known data (investors use financial statements and try to forecast future EPS); 3. React to errors in their forecasts, when revealed, by adjusting the price at which shares are traded. If there is an error in the forecast about the EPS, or if the actual information is different to the forecasted figures, it ll be compared and share price would be adjusted accordingly. If it s a surprise to the investors, they ll react to the information when it becomes known. 4.2 Research Design Measure the forecast error in EPS. Use the Random Walk Model to calculate expected EPS. This is the easiest model. EEPS are for firm i at time period t = AEPS (for firm i, at time t 1). Forecasts by analysts are based on previous years. Where: i is a subscript for each firm t is a subscript for time Expected EPS(i,t) = Actual EPS(i,t-1) E.g. Forecast error(i,t) = actual EPS(i,t) - expected EPS(i,t) You would expect it to equal to $150. To get the forecast on EPS, we need to take actual EPS (i, t) minus EPS (i, t). This shows us that the $50 were overestimated. This is bad news to investors. If the difference is significant, you can expect the share price to shift. If there is a SP revision, users will find the information relevant. 4.3 Market Model To measure investors reactions - the abnormal (or unexpected) return in share price, we use the Market model (from Finance literature). This model gives us the expected return for a firm at a particular point in time. R(i,t) = α(i) + β(i)rm(t) + U(i,t) R(i,t) Actual return for firm i at time t α(i) Average/constant return for firm i β(i) Coefficient (weighting) factor for i that measures risk exposure for firm i, relative to the market Rm(t) Return due to effects on market at time t U(i,t) Return due to firm specific factors for firm i at time period t

3 In theory, U(i,t) isn t directly observable. Return in SP are affected by: 1. Market events: create systematic (market) risk,e.g.which affects all firms on the market in the same way, but to varying degrees. Market events Reserve Bank announces an increase or decrease in the interest rate or OCR (which affects IR). The SP of all firms on market is at same rate, but at varying degrees. If the interest rates increase, the SP will decrease as investors will earn more in the debt/money markets. It has to be a surprise, though. An increase in inflation erodes returns investors can earn on the share market. 2. Firm specific events: They impact on risk and effect SP. Market events create systematic risk, which affects all firms on the market in the same way up to varying degrees. Firm specific events create unsystematic risks. If a firm made a surprise announcement of earnings, their SP would shift, and other firms won t as earnings are unique to that firm. Finance theory tells us that unsystematic risks can be reduced if the investor holds a diversified portfolio of shares. Positive or negative returns related to unsystematic risk offset the effect on the firm. Share prices affected by market effects & firm specific effects, which impact on risk. If fully diversified, only market effects should matter. 4.4 Estimating the market model E[R(i,t)] Expected return of i at t a(i) an estimate of α(i) b(i) an estimate of β(i) Rm(t) what really matters E[R(i,t)] = a(i) + b(i)rm(t) To find an estimate of U(i,t), let AR(i,t) be the abnormal return & define as: U(i,t) AR(i,t) = actual return - E[R(i,t)] E.g. Above is a firm specific return from a theoretical equation This shows the estimate E[R(i,t)] = Rm(t) of a(i) is 5%, and the Rm(t) = E[R(i,t)] = x estimate of b(i) is 1.2. = 0.20 R(i,t) = 0.15 (15%) AR(i,t) = = 0.05 AR(i,t) is the abnormal return for i at t. There is a relationship between forecast EPS and SP, as shown by the abnormal return. Is this 5% related to the $50 EPS? EPS is bad news, so SP would be revised negatively. Whether there s an association between the forecast error and EPS, and AR and SP, and if the forecast error is a surprise, is unexpected to investors, we d expect SP reaction to that information upon release. 4.5 Research Process The sample consists of 261 NYSE firms from The test: Find monthly:

4 Average AR(i,t) 12 months prior to the EPS announcement; & Cumulative abnormal return (CAR) (the sum of monthly average AR up to month being examined) Form 2 groups from EPS forecast errors: Positive changes, good news (first group result was better than expectation); Negative changes, bad news (EPS is less than expected EPS) This shows the timeline pre-and-postannouncements for the good news firms. t at 0 is where the firm makes the earnings announcement is the abnormal return for first firm12 months prior to the earnings announcement. = Σ, If you had all the numbers, you d calculate the cumulative abnormal return, which is what Ball and Brown tried to do. Test the following hypothesis: Good (bad) news group should be related with positive (negative) changes in CAR. 4.6 Results Hypothesis were supported - accounting numbers have information content; 1. Greatest AR around EPS announcement date; 2. Accounting numbers are not the monopoly supplier of information to investors. There are other information firms provide to the market which causes the SP reaction or revision. In the months prior to EPS announcement, there is SP reaction/revision. Information could be released of semi-annual/quarterly earnings; 3. Market is semi-strong efficient i.e., reacts quickly and unbiasedly to new info (the Efficient Markets Hypothesis - EMH). Once the earnings are announced, market reacts quickly and unbiasedly to new information. Investors can t make AR based on what is there (EMH).

5 The space after the announcement date shows the line becoming flat. If you look at the difference between any month after EPS announcement, it would be zero. You can t make money trading on shares once the earnings are announced. AR are very small, or equal to zero. There is a reaction for good news firms when there was a positive outcome. When the bad news firms forecast, there is a negative reaction in the SP as shown by CAR. If it is new news to the investors, they ll revise the SP positively or negatively, according to the news. The study justifies why accounting information is important to investors. There is a share price reaction when firms release earnings. There is a strong relationship between the forecast error and EPS, and the abnormal return and SP. Also, the greatest abnormal return happens when the earnings are announced. They re announced at time period 0. Other information markets react to are firm specific events. Pay Attention: When firms make earnings announcements, analysts compare those with prior years. Although it s an old study, it still applies today. Fletcher Building announced they were downgrading their earnings forecast, which resulted in a significant decrease in the SP. Key: EPS difference has to be a surprise for there to be a SP reaction. 5. Research since B&B (1968) 5.1 The size of unexpected EPS & ARs: Is size & sign of unexpected EPS related to size and sign of AR i.e., is most positive (negative) error in EPS related to most positive (negative) change in AR? See studies by Beaver, Clarke and Wright (1979), & Foster, Olsen and Shevlin (1984) In the studies, the size of UEPS was found to be related to size and sign of AR. Results: Hypothesis supported

6 The study doesn t talk about the forecast of EPS. If a firm has reported a large forecast of EPS, would there be a large reaction? As shown, the results are consistent with B&B (1968). Instead of grouping firms in 2 groups, they group them in 10 groups (or portfolios). The 1 st Portfolio represents firms with the most negative forecast of EPS, and Portfolio 10 shows firms with the most positive forecast of EPS. Portfolio 1 is the worst performing firms in regards to earnings, and Portfolio 10 is the best performing in relation to earnings. All other portfolios represent other degrees, e.g. Portfolio 2 is the second worst, and so on. They represent a ranking order. Portfolios 4 and 5 have the smallest forecast errors in EPS. Actual EPS is close to the forecasted EPS. The Y axis is CAR (measure of SP reaction). Portfolio 1 has the worst SP reaction and Portfolio 10 has the best SP reaction. Portfolios 4 and 5 show information that too much of a surprise to the investors, so the revision/reaction is very small. Portfolios 5 to 10 have a positive SP reaction, and Portfolios 1 to 4 have a negative SP reaction to the EPS. This study goes further than B&B as it takes size into consideration. 5.2 Accounting changes and share prices Can markets be fooled by accounting changes that have no cash flow consequences? When recognising depreciation expense, we re recognising the accrual. Total depreciation expensed in the long run, over 2 years, is equal to $100. In the long run, there doesn t appear to be any cash flow consequence from using either SL or accelerated method. Choosing one method or the other shouldn t have any short-term effect on the value of SP of firm because cash flow consequence is the same. SL method could be thought of as the income increasing method, whereas Accelerated Depreciation is seen as income decreasing method in the short term. This effect has to reverse out in year two. If a company switches from one method to another to make things look better than they are, do the investors naively increase the SP of the firm? Hypotheses investigated: H1: Naive-investor hypothesis (NIH) - market mislead by accounting methods with no cash flow implications, i.e. People in the market (investors) are dumb, and react/are misled by changes in

7 accounting policies. H2: No-effects hypothesis (NEH) - market will not react to accounting methods with no cash flow implications, i.e. accounting works. Investors can see behind the accounting policies, they look at the long run vs short run effects. There has to be a cash flow consequence for there to be a SP reaction. Ball (1972) Examines 267 accounting changes Sample consists of 197 companies, Results: Reject NIH & accept NEH But, there are some concerns with the Ball study: Concern 1 Effect on earnings & share price is unclear. He isn t sure if earnings would increase or decrease as a result of the accounting policy changes. Concern 2 Changes with & without cash flow effects included. If he has accounting policy changes with cash flow consequences, but there are no share price reactions. Remedy He suggests that we should analyse accounting policy changes by type, rather than by grouping them together. One policy he focuses on is accounting policy change in relation to inventory, in particular the choice between LIFO and FIFO method of valuing inventory. 5.3 Changes with direct cash flow consequences - the FIFO/LIFO example Financial effect: FIFO (LIFO) increases (decreases) earnings. Even though the inventory valuation method is an accrual accounting procedure, changing has a cash flow consequence on firms. This means that there is some sort of market reaction when firms change inventory valuation method from FIFO to LIFO. All we re doing is altering the timing in which the purchase price of the inventory is applied to it when it s sold. In the long run, you should get the same result in terms of what the cost of inventory is sold, no matter whether you use FIFO or LIFO, but this research shows there s a cash flow consequence. How would market react to the change? No reaction? Negative reaction? Positive reaction? Early researchers have found a positive reaction. We are altering the timing. Over the long run, the earnings, using either number should be same. We regard FIFO as an income increasing technique and LIFO would be an income decreasing technique.

8 E.g.FIFO/LIFO Firm has opening inventory of 5 $10 each (under both FIFO & LIFO). During year: - 5 units are $15 each; & - 8 units are $20 each Required - Based on these facts, calculate the firm s earnings for the current year. Results: Early studies find - There is a positive reaction to the change LIFO. Reaction appears to arise because of tax savings from using LIFO i.e., lower earnings are reported, less tax to pay. Because FIFO has a lower COGS figure relative to LIFO, all things else being constant, earnings under FIFO are higher than LIFO in the short run, assuming inventory prices are increasing. These findings are specific to US only, as companies aren t allowed to use LIFO in NZ. The direct cash flow consequence from this is that going from FIFO to LIFO results in tax changes, which affects SP. In the US, firms are allowed to use LIFO for tax purposes. If they use it for tax purposes, they also have to use LIFO in financial statements. They ll thus report lower earnings, and will pay less tax, relative to if they were using FIFO. From a firm s POV, that s a good thing as you re paying less tax and there is more cash available. Tax savings generate positive cash flows and an increase in investment in the firm as the funds could be redirected to other areas. The freed-up cash, if not reinvested in the firm, can be used to pay a higher dividend to the shareholders. More recent research shows that there is a negative reaction to the change to LIFO. This is counter intuitive to previous findings, and is not because the market is naïve. The negative reaction could be due to adverse indirect cash flow consequences from changing to LIFO that affect firms, such as higher agency costs. The policy change has an indirect impact on the wealth of the owners and other stakeholders. It doesn t relate to a taxation impact. Higher agency costs offset positive direct cash flow consequences (from switching from FIFO to LIFO), tax savings are lower than agency costs. Agency costs have an indirect cash flow consequence on the firm, and especially on shareholder wealth. Switching might prevent firms from paying dividends to shareholders. 6. Summary Accounting numbers are important to the functioning of capital markets Market is semi-strong efficient Investors are not naive

9 7. Implications on Regulators Let firms report any accounting method(s) they like, as long as enough info is provided to permit adjustment to other method(s). If we reject NIH, there is no point debating which method firms use to report financial statements. We shouldn t tell firms what to use to report. As long as they provide users enough information to adjust accounting methods, they can use any method. Justification? Investors in the market are sophisticated enough to interpret implications of using alternative accounting methods to account for transactions. But, does it happen? No. it doesn t happen because we live in an imperfect world. True free markets don t always resolve problems we encounter. We see stock markets crashing and companies employ false accounting to mislead users. If we have true free markets, they don t seem to be able to resolve these issues. Fuji have been in the news as they ve been found guilty of inappropriate accounting, and an investigation is going on as to why the results are misleading.

10 ACCTG311 M2: The Theory of Accounting Choices 1. Introduction Objectives - Discuss contracting cost theories and explain why firms exist; and Focus on one particular contracting cost theory: Agency theory, which helps understand accounting practices. 2. Theory of the Firm Contracting cost theories are concerned with firms and why they exist. When we have a price and a market system, all that is needed is the tastes and participation to make the most effective resource allocation decisions. In firms, we see a person in authority doing the resource allocation (entrepreneur or manager). The firm for particular transactions can make more efficient resource allocation decisions. In economics, markets are considered efficient & effective in making resource allocations. Prices get established by the forces of demand and supply, and reflect the relevant information an individual would need to make the most effective resource allocation decision. But we often see firms replacing markets to do this. Why? This is a question that was asked by Coase (1937). Why do we see firms replacing the market system in specialised exchange economies? Markets sometimes involve (high) contracting costs. Contracting costs are important as they determine why firms exist. When you carry out transactions, you incur contracting costs. 3. Coase s (1937) Argument 1. Firms exist to minimise contracting costs. Costless contracting is not realistic. Firms exist as they can minimise contracting costs better than if the transactions were carried out in market/price systems. Insight implies costless contracting isn t realistic, as there is always some cost involved. If it was realistic, all transactions would be carried out in market systems. 2. Competition between markets & other firms ensures firm survives. Structures we observe are, and must be the most cost efficient contracts e.g. contractual arrangements, accounting and management control systems firms use. The firm must be continually evolving, coming up with new ways to be more cost efficient. It has to evolve as the operating environment is constantly changing. 3. Firm can be defined as a nexus of contracts. The firm is an intermediary between a number of contracting parties. It is trying to minimise its contracting costs e.g. suppliers, creditors, employees, shareholders, customers, etc. If firms are minimising their contracting costs, they are maximising the firm s value. Example Consider you wish to own a chair. You essentially have 2 choices: - Make chair yourself by transacting for materials in a market, which can be a costly exercise.

11 ACCTG311 - Buy the chair from a firm, which may be cheaper because of cost savings due to: o No. of contracts negotiated being reduced o Firm is a specialist in contracting, and has economies of scale in repetitive contracting If you are consumer 1, you may have to negotiate a contract with Resource Owner 1 for wood price, and Resource Owners 2 and 4. You keep on doing this until you have everything you need to own a chair. This exercise of identifying a Resource Owner, negotiating, agreeing on a price, etc. can be costly. The cost of contracting is calculated by seeing how many contracts get negotiated e.g. 9 in this example. The total contracts being negotiated is a good measure of contracting costs. This shows that there are 6 contracts to be negotiated. The firm is an intermediary between other contracting parties Consumers and Resource Owners. The firm negotiates with Resource Owners to buy materials to make chairs. Consumers don t have to contract with Resource Owners for materials to make a chair, the firm does that. Contracts are reduced when dealing with firms, so it s less costly. 4. Implications of the Theory of the Firm on Accounting Role of firm is to create & use technologies that make it efficient (i.e., to minimise contracting costs)

12 ACCTG311 Accounting is one of these technologies, which is the main implication. If the firm is minimising contracting costs, it s maximising its value. If it doesn t, it won t survive. Accounting makes it cost efficient, as it provides information firms need to minimise contracting costs by making appropriate resource allocation decisions. 5. Types of Contracting Costs Five general types of contracting costs are identified in the economics and accounting literature: 1. Transaction costs (costs of transactions) 2. Information costs (costs of being informed e.g. annual reports) 3. Renegotiation costs (cost of rewriting obsolete contracts) 4. Bankruptcy costs (financial distress) 5. Agency costs We want to focus on agency costs, because research shows that agency costs seem to be related to firms accounting policy choices. 6. Agency Theory Examines agency relationships, which is defined as a contract under which one or more persons (principal(s) [P]) engage another person (the agent [A]) to perform some service on their behalf which involves delegating some decision-making authority to the A. Jensen & Meckling (1976) A key assumption in agency theory (& indeed in economic analysis) is that individuals and firms are rational self-interested wealth maximisers. In the context of firms, the firms managers are the agents and other contracting parties would be principal (shareholders, customers, suppliers, etc.). Firms managers will always be agents in agency relationships. individuals aren t concerned with the wealth of those they re dealing with, only themselves self-interested wealth maximisers. Assumption is important as conflict of interest may arise, agent doesn t do what they re meant to for the principal, which is called opportunistic behaviour. When there is a conflict of interest, it gives rise to agency costs. 7. The Agency Problem Conflicts of interest can arise between P & A, and such conflicts create agency costs: - Monitoring expenditures by P. They ensure the agent is doing what they re meant to for the principal e.g. cost involved in specifying policies the firms will follow, cost of hiring auditors (to check the work of the agent, etc.; - Bonding expenditures by A. Incurred by the agent, and are expenditures that attempt to convince P that what A is doing is in the interest of P. E.g. when a firm produces an annual report or other financial statements, those statements tell P what the A has been doing. - Residual loss (or opportunism). Loss in value of the firm from conflicts of interest that can t be resolved by spending on monitoring or bonding expenditures. Monitoring and bonding expenditures help align interests of P and A, by reducing conflicts of interest. They have to happen; as costless contracting isn t possible. This reduces residual loss and contracting costs. They happen before a contract is agreed upon. They are good expenditures to incur, unlike residual loss. If an agent is going out trying to deceive P, if there is a residual loss, you re not minimising contracting costs or increasing/maximising firm value. residual loss happens after a

13 E g. lu t a i g th t con cts o nte e t a e os y s nce ACCTG311 contract has been agreed upon. If residual loss does happen, the agent bears the cost because P can price protect. When P negotiates with A, P can see future conflicts of interest, so conflicts of interest are included in contracts. If an agent is opportunistic, P has already prepared for it. E.g. Norman might offer me a salary of $100,000, assuming that I won t be opportunistic. If he thinks that I will be, he ll offer $80,000. If I am opportunistic, Norman has already priced it in, so ultimately, I, the agent, lose. A has to convince P that they won t be opportunistic to get the best deal. P can foresee conflicts of interest here, but in reality, we can t. In reality, P may bear costs of A being opportunistic. Ultimately, A bears cost of being opportunistic. Why? - P can price protect. That is, P is able to foresee conflicts & price these into the contract with A - Hence, it is in the interests of A to contract with P to limit the amount of their opportunistic behaviour - Realistic? Only if we assume a perfect world 8. Two Important Agency Relationships 1. Shareholder (P)/manager (A) conflict If manager owns none or small fraction of firm, a conflict of interest between manager & shareholder may arise. The manager will take actions which benefit them, and not the shareholders non-pecuniary benefits. Expect manager to: - Shirk: take days off, or take long lunch breaks. - Consume perks: use of company car or personal trips, redecorating the office and spending too much of the firm s money, having multiple secretaries, etc. Managers, through their actions, abuse authority which harms shareholders, thus minimising firm value. Shareholders bear costs; but manager enjoys benefits. The incentive to be opportunistic is more extreme if the ownership status is small or none at all for the manager. Opportunism is a function of manager s ownership stake. But, who actually bears the costs ultimately? Since shareholders can price protect, the costs of being opportunistic are borne entirely on manager. Managers thus have an incentive to align interests with shareholders by contracting with shareholders to limit their amount of opportunism. Things shareholders can do to price protect is by valuing the firm at a higher cost capital, they pay less when buying into it, or they can decide to not buy into it at all. They align their interests by having a contract with the shareholders. What type of contract can reduce the opportunism? Before we can answer this, must ask what are the contracting parties incentives? - Shareholders want to maximise firm value/earnings, which can be achieved by maximising earnings which can be a measure of future cash flow. - Managers want to maximise their wealth by getting a fair remuneration package. Align incentives by negotiating a bonus plan contract: - Base bonus on earnings performance. A Bonus Plan Contract is where a bonus is only payable if certain targets are reached. The bonus can increase as a positive linear function of the

14 ACCTG311 earnings number, above whatever the target earnings are. An accounting number is used to define and monitor the contract as it sufficiently aligns the interest of the two parties. - The higher earnings are, the higher the bonus that managers receive 2. Debtholder (P) / Firm (A) conflict If a firm borrows funds, the firm may be opportunistic by taking any of the following actions: 1. Pay excessive dividends: The firm is borrowing on the assumption that firm is paying a certain amount to shareholders. The firm subsequently increases the dividend, which the debtholders aren t aware of. This is opportunistic, as shareholders get benefits, but debtholders lose our as dividend increase could be used to pay back the debt and reduce interest, or it could be reinvested in the company. 2. Dilute existing debt claims: When firms get debt, they rank it for if the firm needs to liquidate (who gets paid first). Existing shareholders don t like firms issuing new debt. 3. Substitute low risk investments for high risk investments (asset substitution/risk shifting): Firms tell creditors the debt they re taking out is for low risk investment, but it s actually going towards a high risk investment. This is opportunistic as if they were told it is high risk, the firm would have been charged a much higher interest rate. The probability of getting paid off in high risk is low, but if paid off, the return is high. The high payoff is not shared with the debtholders, so they miss out. 4. Forgo positive NPV investments (underinvestment): The payoff might go entirely to the debtholders, as the firm s incentive is to not invest in the positive NPV (Net Present Value) investments as shareholders don t get anything. Debtholders like this as it provides more funds for reinvestment in the firm. These actions transfer wealth away from debtholders to the firm, but debtholders aren t naïve and can also price protect. They can cease lending to the firm, charge high interest so if the firm wants the money, they ll either take it or convince the debtholders that they won t be opportunistic. Hence, the cost of being opportunistic is borne entirely on firm. Firm has incentives to align its interests with those of the debtholders by contracting. What type of contract can be used to reduce the opportunism? Again, before we can answer this, must ask what are the contracting parties incentives? - Debtholders want to protect their investment, and ensure the funds lent will be repaid along with the interest. - Firms want to maximise their value for shareholders. They ll negotiate contract with debtholders in which provisions (restrictive covenants) will say what firms need to and cannot do. Align incentives by negotiating a debt contract that specifies restrictive covenants: 1. Can t pay dividends while interest unpaid 2. Can t sell major assets without debtholders approval 3. Accounting based restrictions on borrowing, which is very common in debt contracts. Accounting based defined restrictions are extremely common in debt contracts. Examples include not being able to borrow and/or severe financial (or other) penalties if: 1. Current Assets - Current Liabilities < $ XXX: it can t be below a certain amount. 2. EBIT / Interest Expense < 3: Debtholders want < 3, as then it s not problematic. 3. Total Liabilities / Total Tangible Assets > 0.6: The leverage ratio shouldn t exceed 60%. If the firm has leverage ratio greater than 60%, they ll be penalised for breaching the covenants.