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Chapter 5
The Information Approach to Decision
Usefulness
Chapter 5 The Value Relevance of Accounting Information
5.1 The Value Relevance Approach
> Continued
Outline of the Research Problem (continued)
>> Continued
Outline of the Research Problem (continued)
» Continued
Outline of the Research Problem (continued)
Outline of the Research Problem (continued)
• Unexpected earnings
– Investors have expectations of current earnings
– Investors’ expectations are built into share price prior to release of
current earnings
• Assumes market efficiency
– When current earnings released, investors will react only to unexpected
component
– Investors’ earnings expectations unobservable
– How to estimate unexpected earnings?
>> Continued
Outline of the Research Problem (continued)
• B&B methodology
– For Each Sample Firm:
• Estimate investors’ earnings expectations (proxied by last year’s actual)
• Classify each firm as GN (actual earnings > expected earnings) or BN
(vice versa)
• Estimate abnormal share return for month of release of earnings
(month 0), using procedure of Figure 5.2
» Continued
The Ball and Brown Study (continued)
• B&B conclusion
– Stock market reacts to earnings information in month zero, but begins
to anticipate the GN or BN in earnings 12 months prior
– Consistent with securities market efficiency and underlying rational
decision theory
>> Continued
The Ball and Brown Study (continued)
• Causation v. association
– Narrow Window Studies
• Evidence that financial statement information causes security price change
– B&B month zero is narrow window
– Wide Window Studies
• Evidence that financial statement information is associated with
security price change
– B&B months -12 to -1 and 1 to 6 are wide window
– Narrow window studies more consistent with decision usefulness
> Continued
The Ball and Brown Study (continued)
• A different question
– Does quality of earnings affect magnitude of abnormal share return?
• Conceptually, quality of earnings is measured by the main diagonal
probabilities of the information system
– Higher main diagonal probabilities implies higher quality
• In practice, earnings quality often measured by:
– Earnings persistence
» higher persistence → higher quality
– Accruals quality
» DeChow & Dichev (2002)): higher accruals quality → higher earnings quality
Definition of ERC
5 - 19
Earnings Response Coefficients (continued)
>> Continued
Earnings Response Coefficients (continued)
>> Continued
Reasons for Studying ERCs
5 - 22
5.4.3 Measuring Investors’ Earnings Expectations
5 - 23
A Caveat about the “Best” Accounting Policy (continued)
5 - 25
5.7 Conclusion