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Financial Accounting

Theory Seventh Edition

William R. Scot

Chapter 5
The Information Approach to Decision
Chapter 5 The Value Relevance of Accounting Information
5.1 The Value Relevance Approach

• Assumes securities market efficiency

• Investors responsible for predicting future firm performance
– Role of financial reporting to provide useful information for this
• Usefulness of financial statement information evaluated by
magnitude of security price response to that information
– Helps accountants to evaluate decision usefulness of different
accounting policies
5.2. Outline of the Research Problem

• Reasons for market response

– An application of decision theory model
• Investors have prior probabilities of future firm performance
• Investors obtain useful information from financial statements
• Investors revise their probabilities
• Leads to buy/sell decisions
• Security price and share return change

> Continued
Outline of the Research Problem (continued)

• Abnormal share return

– Most value relevance studies examine effect of earnings information
on return on firms’ common shares
– Total share return = return due to market-wide factors ± abnormal
return due to firm-specific factors
• Abnormal share return can be atributed to financial
accounting information
• If good news in financial statements leads to positive abnormal share returns
(and vice versa), conclude financial statement information is useful.
• To reach such a conclusion, need to separate market-wide and firm-
specific share return

>> Continued
Outline of the Research Problem (continued)

• Separating market-wide and firm-specific returns

– Firm releases financial information
• Most studies look at release of earnings
– Use a market model to estimate market-wide return on that day (or
narrow window)
• Assumes market efficiency
– Abnormal share return during narrow window = total return – market-
wide return
– See Figure 5.2

» 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
– Investors’ earnings expectations unobservable
– How to estimate unexpected earnings?

>> Continued
Outline of the Research Problem (continued)

• Estimation of investors’ earnings expectations

– Time series approach
• Based on earnings in prior years
– Analysts’ forecasts
• Available for most large firms
• Now the most common approach
Outline of the Research Problem (continued)

• Finally, compare abnormal share return with unexpected

– If positive unexpected earnings is correlated with positive abnormal
share return, and vice versa, suggests earnings information is decision
5.3 The Ball and Brown Study

• The first study to document statistically a share price

response to firm-specific component of reported net
income (1968)

• Methodology still in use today

The Ball and Brown Study (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 methodology (continued)

– Calculate Average Abnormal Share Return for GN Firms in the sample
for Month 0
– Dito for BN Firms
– Repeat for Months -1, -2,…,-11, and Months +1, +2,…,+6
– Plot Results
• See Fig. 5.3, next slide
B&B Results
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)

• Research in years following Ball & Brown

– Does amount of abnormal share price change correlate with amount of
GN/BN in earnings?
• Amount of GN/BN = expected earnings - actual earnings
• Answer: Yes
– With quarterly earnings reports? Yes
– On other stock markets? Yes
5.4 Earnings Response Coefficients

• 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

•An earnings response coefficient (ERC) is

abnormal share return divided by unexpected
– That is, ERC is abnormal share return per dollar of
unexpected earnings
•Question then is
– Does higher earnings quality result in higher ERC?
• For earnings quality measured by persistence: Yes
• For earnings quality measured by accruals quality: Yes

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Earnings Response Coefficients (continued)

• Characteristics affecting ERC

– Risk (ß): higher ß → lower ERC
– Capital structure: higher D/E → lower ERC
– Earnings quality:
• higher quality → higher ERC
• Important components of earnings quality
– Earnings persistence:
» higher persistence → higher ERC
– Accruals quality
» DeChow & Dichev (2002)): higher accruals quality implies higher earnings quality

>> Continued
Earnings Response Coefficients (continued)

• Factors affecting ERC (continued)

– Growth opportunities: higher opportunities, higher ERC
– Similarity of investor expectations: more similar, higher ERC
– Informativeness of price: more informative, lower ERC
• Firm size as proxy?

>> Continued
Reasons for Studying ERCs

• ERC research has greatly improved accountants’

understanding of how market responds to reported earnings
• Beter understanding enables preparation of more useful
financial statements
– E.g., Financial reporting policies that produce a higher ERC are more
decision useful for investors

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5.4.3 Measuring Investors’ Earnings Expectations

Time series approach

• Depends on earnings persistence
– Earnings 100% persistent
» Unexpected earnings = change in earnings
– Earnings zero persistence
» Unexpected earnings = current year’s earnings
– Analysts’ forecasts approach
• Evidence suggests more accurate than time series
– Unexpected earnings = analyst forecast error
– Older forecasts tend to be less accurate
– Are analysts biased?

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A Caveat about the “Best” Accounting Policy (continued)

• While accounting policies that produce the highest ERC

may be most decision useful for investors, they may not be
best for society
• Accounting information as a public good
– Investors who do not pay for accounting information will demand
more of it than socially desirable
– Implication is that standard seters cannot be sure that an accounting
policy that has a higher ERC than another is socially beter.
– Complicates standard setting
5.6 Value Relevance of Other Financial
Statement Information
• Balance sheet
• Hard to find since more difficult to know when investors first become
aware of B/S information
• Supplementary information
• RRA: mixed evidence
• Financial statement notes
• Evidence of market response following the date firms report to SEC
• Response driven by financial analysts who pounce on the data
• MD&A:
• Li (2010), Section 3.6.4
• Brown & Tucker (2011), Section 3.6.4

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5.7 Conclusion

• Security market response to accounting information supports

rational decision theory and efficient securities market theory