Module Four. The Information Perspective on Decision Usefulness. Module 4 Five Parts. Part 1 The Information Perspective

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1 Module Four The Information Perspective on Decision Usefulness 1 Module 4 Five Parts Part 1 - The Information Perspective Part 2 - The Research problem Part 3 - The Ball and Brown Study Part 4 - Earnings Response Coefficients Part 5 - Public and Private Goods, Information Content of RRA, and Conclusion 2 Part 1 The Information Perspective Handout Objective Accounting Information Information Approach points to note 3 1

2 Objective The Information perspective is the equating usefulness of information with the content of information If efficient market theory and decision theories are sound and acceptable, then the values of securities in the markets will respond in a predictable way to new information We also cover research into the question of expected normal returns and abnormal returns, after which we deal with studies in response of shares in the market to good and bad news 4 Accounting Information It appears when we use net income as a main figure, accounting information would seem to indicate that the market is efficient and it impounds information, reflecting such information in the price of the security Accounting information helps investors in determining an estimate for the expected value, variance and risk of security returns based on prior probabilities And Bayes' Theorem can give additional information 5 Information Approach points to note: Investors want to make their own predictions Accountants can use market response to determine what investors want We should not necessarily equate usefulness with price change We have to consider the cost of information. Making up an annual report takes time and money In summary, from an ethical and social point of view the accountant's responsibility is to give the investor and the public the best information possible 6 2

3 PART 2 The Research Problem Major Points: The Research Problem Predicting Investor Behaviour Process Test Market-wide and Specific Factors 7 The Research Problem In researching to find whether good news or bad news affects share price, it is necessary to find the narrow window of reaction, the days around the time when earnings news is released, to determine whether or not share price is affected 8 Predicting Investor Behaviour In our research we want to predict investor behaviour Prior to release of net income figures investors have prior beliefs When net income is released, some investors will become more informed If expectations change they will buy or sell as the case may be Thus volume will increase around time of release of net income figures 9 3

4 Predicting Investor Behaviour Beaver found a dramatic increase in the number of shares traded during the week of release of earnings announcements This appears to follow the efficient market theory 10 Process Test To test these predictions, a test could be as follows: A sample of firms examined to see if the volume and price of their shares were affected During the time of release of the annual report (within a day or two, or three of release) 11 Process Test The good or bad news is evaluated in relation to what investors expected. If net income were higher than what was expected this would be good news How would you determine what investors expected of net income 12 4

5 Process Test Some ways: Looking at analysts' forecasts of earnings Estimate net income by projecting time series or indexes Then net income could be separated into expected and unexpected income 13 Market-wide and Specific Factors The course gives an example of how expected and unexpected income may be separated into expected returns - systematic risk, and unexpected or abnormal returns - firm specific risk. Time is Day 0 Now follow the Handout page 6 14 Market-wide and Specific Factors We can also use CAPM to separate expected and unexpected The first two terms are the expected rate and the last one the unexpected R jt = Rf (1 -βj) + βj (R mt ) + ε jt,,, or 0.15 = 0.05(1 0.80) (0.10)

6 Market-wide and Specific Factors Explanation re CAPM There is a constant of 1%, which is the intercept (0.05 (1 0.8)) The beta of firm j is.80, the slope of the line. This line delineates the expected from the unexpected. If the beta is.8 and the market return 10%, gives 8%, plus 1%, to equal 9% expected. The actual return of firm j is 15%, thus there is an unexpected return of 6%, which is ε jt Epsilon 16 Market-wide and Specific Factors To increase the effectiveness of the research, the same process may undertaken for a few days before and a few days after day 0 Note: while there are two ways to separate the abnormal and expected returns, on an examination if it asks the student to use a specific method, for example, the geometric method, use that method. If it does not specify, then you would appear to be free to use either method 17 Market-wide and Specific Factors If positive and negative abnormal returns are seen to correlate with good and bad news, respectively, then the researcher can conclude with some foundation that the decision theory and efficient market theory are well-founded 18 6

7 PART 3 The Ball and Brown Study First study which provided scientific evidence that firms' security market prices responded to the information content of financial statements Brief review of study They concentrated on earnings Their measurement was quite rough 19 The Ball and Brown Study Their measure was to assume that the market's expectation of current earnings was equal to last year's actual earnings In summary taking all the GN earnings announcements in the sample and the related returns, it was found that "the average abnormal security market return in the month of earnings release was strongly positive and the average abnormal returns for BN earnings announcements was strongly negative. This substantiated that the market did respond to good or bad news 20 The Ball and Brown Study Refer to Handout page 10 Note that the study used averages of the variables of all the firms Variable 1 - reported net earnings Variable 2 - earnings per share as the earnings measure Variable 3 - times series approach to calculating expected earnings per share Note there is shown 12 months prior to the annual report date, and 6 months after 21 7

8 The Ball and Brown Study Two reasons suggested for this drifting effect: The market may be able to glean out the GN or BN effect prior to announcements Market prices could be reflecting public information and possibly alerting investors to the months ahead In summary the study suggests that market price and net income are "positively correlated" 22 The Ball and Brown Study Outcome The value of the Ball and Brown study and the outcome was that it opened up many additional usefulness issues Beaver, Clarke and Wright did a study to determine if the magnitude of unexpected earnings and magnitude of market response were related The study revealed that the greater the change in unexpected earnings, the greater the security market response in line with decision usefulness 23 Part 4 Earnings Response Coefficients Major Topics ERC s Beta Capital Structure Persistence Growth Opportunities Information from price What are the implications of ERC's 24 8

9 Earnings Response Coefficients The B&B study related to averages, which are made up of a variety of numbers. For individual firms some abnormal returns could be well above the average and some well below Question - So does the market respond more strongly to good and bad news for some firms than it does for others 25 Earnings Response Coefficients Some study has been done to identify different market responses to earnings information. - "earnings response coefficient" (ERC) research. Note: The higher the coefficient the higher the response A number of reasons are suggested for the differential market response to historical cost-based earnings 26 Earnings Response Coefficients Beta A stock with high beta is riskier than a stock with a lower beta. If a security with a high beta has GN earnings information, an investor is likely to be optimistic about buying those shares However, to buy those shares it will increase the risk of the portfolio and they are not likely to buy the shares Thus, a high beta acts as a brake on the demand for the security 27 9

10 Earnings Response Coefficients Capital Structure For highly levered firms, much of the good news earnings is passed to the bondholders Their security is enhanced and really an advantage over the shareholders Thus for more highly levered firms the ERC is lower 28 Earnings Response Coefficients Persistence How long will the good or bad news persist into the future. Will the abnormal earnings persist Probably one of the most important factors to the investors If the good news were due to a breakthrough with a drug that would cure certain types of cancer this is more likely to be attractive as good news to investors because of the greater possibility of long-term earnings than say an extraordinary item sale which brings in additional earnings for one year 29 Earnings Response Coefficients Thus the increase in earnings in the case of the extraordinary item will last only one year and the ERC will be 1. It may even be zero if the earnings increase had been anticipated earlier Your notes also talk about historical cost and market value statements. In market value all changes in the assets are comprehended in the period, then the persistence measure would only be

11 Earnings Response Coefficients If, however, under historical cost there is a continuous increase year by year, as it is not captured in the first year, there could be a greater than one persistence ERC It has been found that ERC's are higher when the persistence of unexpected current earnings changes are higher Note on page 133 of the text where the author discusses three types of persistence 31 Earnings Response Coefficients Growth Opportunities Growth opportunities would intuitively seem to result in higher ERC's, and this has been found in firms that the market envisages as having growth opportunities 32 Earnings Response Coefficients Information from price Price is informative to investors because security prices impound information. Thus the direction of price may help investors anticipate the future and thus there would be lower ERC's resulting. In one study it was found that larger firms have lower ERC's than smaller firms This is understandable as they give out more information than do smaller firms and their price would reflect this 33 11

12 Earnings Response Coefficients What are the implications of ERC's This response on the part of the market would seem to indicate ways of improving decision-usefulness of financial statements Higher ERC's for smaller firms would seem to indicate greater disclosure would be of benefit and lower the response 34 Earnings Response Coefficients With lower ERC's for highly levered firms it would seem to support greater disclosure, including the reduction of off-balance sheet financing. More information on growth would seem to be of benefit to investors. The persistence of earnings would seem to be of importance to investors 35 Extraordinary Items Unusual, Non-Recurring and Extraordinary Items It is essential to disclose extraordinary earnings To bury such earnings in the operating income, would be to mask the situation. To review extraordinary earnings, Section

13 Extraordinary Items They are items which: Are not expected to occur frequently over several years Do not typify the normal business activities of the firm Do not depend primarily on the decision of management or owners 37 Extraordinary Items This section was revised in 1989, which became effective on January 1, 1990, so that there was a reduction in the smoothing of income by management in choosing which items should be included in extraordinary items 38 Extraordinary Items Previously management had considerable leeway in choosing the items to be put into extraordinary items. However, the revision reduced the number of items that could be so included 39 13

14 Extraordinary Items The result was that a number of low-persistence unusual items moved from this category to operating income. This made it necessary to disclose information on those items which were included but not extraordinary. You will see on page 141 that unusual and non-recurring items are to be set out below operating income. However, as your text notes, if they became buried in operating income, without references, the persistence could be overestimated 40 Extraordinary Items The question is asked: Did Section 3480 change, help disclosure? That is a moot point A Signal to Move Slowly Up to this point it would seem to point to the fact that the best accounting policy is that one which evokes the greatest market response 41 Some Questions to Consider See the Handout for some questions page 16 - relating to Earnings Response Coefficients and topics such as extraordinary, unusual and nonrecurring items 42 14

15 Part 5 Public and Private Goods, Information Content of RRA, and Conclusion Public and Private Goods The Information Content of RRA Conclusion 43 Public and Private Goods A Public versus a Private good. A public good is one which we all use, such as roads, and a private good is one which you use (enjoy), such a buying a sweater. It is difficult for one to charge for a public good such as a highway, but not impossible Annual reports tend to be a public good. They are free to you and to me. They are not free. They are charged in the price of the product 44 Public and Private Goods However, they are viewed as being free, with the result as in other demand-supply situations, people take more of the good Individuals may be better off but maybe not society 45 15

16 Public and Private Goods Investors may view accounting information as useful despite the fact that society's costs outweigh the benefits received by a limited number of investors If we think of information as a commodity then, demanded by investors, and supplied by accountants, we cannot rely on demand-supply mechanisms to produce the "right" amount of information because of this public good aspect. The price system does not operate to supply the firm s full cost of producing the information 46 Public and Private Goods Thus from a society point of view we cannot rely on the security market response to advise which accounting policies should be followed. Standard setting bodies should be aware of this Interestingly current value (cost) information was eliminated in the U.S. and Canada 47 The Information Content of RRA The questions to be asked here is RRA information superior to that of historical cost information, that is, is it of value for additional information Magliolo (1986) indicated that RRA lacked reliability in its measure of reserve value. He also concluded that RRA does not measure from an overall point of view, the market value of oil and gas reserves as predicted by theory 48 16

17 The Information Content of RRA The question was asked as to what extent did RRA have increased ability over the historical cost statements A study of 173 producing oil and gas firms was undertaken for the six years from 1979 to 1984, and divided it into two sub periods l979-l981 and l It was found that during the first period both historical cost and RRA information had considerable ability to explain abnormal return and that RRA was useful to investors. However, during the second period neither system had much explanatory power in this respect 49 The Information Content of RRA The results were mixed and it could be concluded that there is fairly weak evidence in favour of having RRA. Another study related to the ability of RRA information to explain the market value of oil and gas assets rather than abnormal returns. It was found that the book value - historical cost - had significant explanatory power for the market value of the assets but the RRA information had some explanatory power, but less than historical cost. 50 The Information Content of RRA Other studies are mentioned but the consistent finding seems to be that historical costs dominates RRA and, if anything, the historical cost material is underused In summary RRA has not proven to be as useful as it was expected to be 51 17

18 Conclusion We can conclude that the decision-usefulness and efficient securities market theories are supported by studies While there may be some study problems, it does seem that the market does not use all the information in the annual report 52 Conclusion It could be a lack of full market efficiency as suggested by the anomalies (we will study in Module 5), or maybe other sources of information supplying such information. Whatever the reason, it seems the information perspective is content to use historical cost supplemented by a variety of other supplementary information. In other words, the process we now have and the use of many footnotes appears to be a choice which accountants should consider very seriously 53 Your Assignments and Tutorials There are times when you need a little help to answer your assignment questions or you come across a problem in the material which you do not understand. Be sure to use your tutorial on the LMS as this can be helpful in doing your course work