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Notes on the study of Ball and Brown (1968) arguments against normative accounting theory. Also shows what the research developed and what other researchers did after.
Notes on the study of Ball and Brown (1968) arguments against normative accounting theory. Also shows what the research developed and what other researchers did after.
Notes on the study of Ball and Brown (1968) arguments against normative accounting theory. Also shows what the research developed and what other researchers did after.
Is accounting information relevant to stock markets?
Historical cost/Fair value? Efficient market hypothesis Expectations Ball and Brown 1968 Beaver 1973 Lemons, Ackerlof 1970 Cost of Capital Disclosure Signalling Functional Fixation Hypothesis Recognition Lag
Before Ball & Brown (1968)
1. Financial statement information prepared under existing reporting rules is
meaningless; (heterogeneous rules, a proverbial apples and oranges issue) and 2. Radical changes in the nature of financial statement information are required. Chambers, 1976; It is futile to expect a "financial position" to be "fairly presented" Due to different measures: historical costs, depreciation, fair value... LIFO FIFO.. Etc Aggregates of such amounts have no meaning whatever; they fairly
present nothing in the nature of a dated financial position.
Only a system of accounting which makes use of one valuation method
will yield intelligible figures for assets and income, Only figures that use consistent valuation method and "dated value in exchange"
Pre BB68 research Issues
data availability The share market was not seen as a suitable area of accounting research. Accounting literature was focused on its own accounting measurement models Demonstrating that financial statements are in some sense imperfect does not mean that they are inefficient and should be changed. Leftwich (1980) A related problem is that financial reporting is an economically costly activity. The existence of pathological cases such as bankruptcies and accounting scandals in which reporting imperfections were subsequently revealed does not imply that the frequency of such cases is too low, too high, or optimal. Andersen and Leftwich (1974) Considerable quantities of other information are used alongside accounting information, and even to explicitly adjust accounting information. An efficient aggregate information environment is not inconsistent with imperfections in any individual source, financial statements included. Fama (1965a, 1965b) made the conceptual breakthrough of framing stock prices as a function of information flows
BALL AND BROWN (1968)
Are accounting numbers useful?
Two derivative questions are: useful to whom? useful for what purpose? The Efficient Market Hypothesis (EMH) is a core component of the BB68 research design EVENT STUDY The event we chose is the announcement of the annual accounting income number, or earnings for the year.
Three statistical measures of the newsworthy component, or forecast errors
they were computed by fitting: (1) a Market Model to the year-to-year changes in prior years net income of the firm and in a self-constructed market index of earnings, Gave consistency between models of earnings changes and of stock returns (2) a similar Market Model of changes in EPS (3) by assuming EPS could be sufficiently well described by a random walk, which we viewed as a special case of the Market Model (when the firms earnings changes were uncorrelated with the earnings changes of other firms, and the firm was stagnant so that the constant term in the Market Model had a true value of zero) Used as a robustness check. The initial objective was to assess the usefulness of existing accounting income numbers by examining their information content and timeliness. Its content is considerable. However, the annual income report does not rate highly as a timely medium Ball and Brown (1968) the relationship between the sign of the income forecast error and that of the stock return residual might have persisted for as long as two months beyond the month of the announcement (1968) because accounting has been practiced for centuries and accounting reports are costly to produce, accounting as an economic activity could not possibly have survived for so long unless there was a demand for it Ball and Brown 2013 Findings Around 85-90% of the price adjustment occurs before the announcement month Possible sources of the leakage of earnings-related information are earlier announcements of dividends, earnings in interim periods, contracts won, production figures, and so forth. However, most of the information contained in reported income is anticipated by the market before the annual report is released. In fact, anticipation is so accurate that the actual income number does not appear to cause any unusual jumps ... in the announcement month (1968) measuring the unexpected component and forecast error in earnings announcements (1968) conducted a variety of robustness tests, including arithmetic versus log returns, different earnings expectation models, an ex post version of the Capital Asset Pricing Model versus the Market Model of stock returns, etc.
AFTER BALL AND BROWN
IX. SOME LITERATURE THAT ENSUED
One reason for the success of BB68 was that it opened up a variety of research possibilities on the relation between financial statement variables and stock prices. The following is a sampling of research that ensued in approximate chronological order:
1. International replication of the results, starting (no surprise here) with
Australia (Brown 1970, 1972);
2. Extending the results to quarterly earnings announcements, in
Brown and Kennelly (1972);
3. Investigating the time-series behaviour of accounting earnings, starting with
the Ball and Watts (1972) verification that the random walk process we assumed when calculating unexpected earnings is in fact a reasonable characterization;
4. Extending the earnings-returns relation to higher moments by studying the
relation between accounting and market measures of risk (Ball and Brown 1969; Beaver et al. 1970);
5. Studying the relation between firms changes in accounting techniques and
their stock prices (Ball 1972). Following the insights of Watts (1977), this work took a radical turn to studying firms opportunistically lobbying standard setters to influence
mandatory accounting techniques (Watts and Zimmerman 1978) and
choosing accounting techniques to influence debt constraints and management compensation (Holthausen 1981). This line of thinking then led to the modern earnings management literature.
6. Earnings forecasts issued by managers (Foster 1973) and analysts (Griffin
1976); Applying the automobile industry analogy above, how can cars be redesigned without any knowledge of how they are driven, what they are used to transport, whether they are simply kept for show, etc?
7. Using daily returns (Foster 1977) and short event windows to estimate linear earnings response coefficients (Beaver et al. 1980; Hagerman et al. 1984);
8. Information transfers between firms that are associated with earnings
announcements (Firth 1976; Foster 1981);
9. The nature and determinants of post-announcement drifts in share prices
(Foster et al.1984; Bernard and Thomas 1990);
10. The distinction between recognition and disclosure
(Beaver et al. 1989).
11. Non-linearities in the returns-earnings relation (Freeman and Tse 1992),
which Hayn (1995) attempted to explain in terms of corporate liquidation options and Basu (1997) attributed to conditional conservatism, under which timely loss recognition generates more large negative transitory earnings components than positive;
12. Earnings decomposition into cash flow and accruals
(Dechow 1994; Sloan 1996);
13. Exploiting cross-regime effects such as international differences (Ball et al.
2000) and differences between private and public companies (Ball and Shivakumar 2005) to better identify the economic and political determinants of important properties of financial reporting, such as timeliness and conservatism.
14. Aggregate earnings and returns (Kothari et al. 2006).