Chapter 5 - THE INFORMATION APPROACH TO DECISION

USEFULNESS
Wednesday, October 23, 2013
12:30 PM

Information Approach
Assuming market efficiency, the market is going to react to any format of information
Accountant has the responsibility to provide that information, in financial information, MD&A, footnotes (doesn't matter)
Information is useful if it leads investors to change their beliefs and actions, which triggers buy and sell decisions, thus affects prices
Information affects people differently, requiring complex cost benefit tradeoffs to balance the competing interests of differ ent constituencies

INFORMATION APPROACH
The information approach to decision usefulness is an approach to financial reporting that recognizes individual responsibili ty for predicting future firm performance and that
concentrates on providing useful information for this purpose. The approach assumes securities market efficiency, recognizing that the market will react to useful information
from any source, including financial statements.
Reasons for Market Response
Investors have prior beliefs about a firm's future performance (dividends, cash flows, earnings), which affect the expected returns and risk of the firm's securities
Prior to release of firm's current net income
Upon release of the current period's net income, some investors will decide to become more informed by analyzing the income number
Using Bayes' Theorem to analyze higher than expected net income (good news)
Investors who have revised their beliefs about future firm performance upward will be inclined to buy the firm's shares at their current market price, and vice versa for
those who have revised their beliefs downwards
Evaluation of riskiness of share may also be revised
We would expect to observe the volume of shares traded to increase when the firm reports its net income
Volume should be greater, the greater are the differences in investors' prior beliefs and in their interpretations of the current financial information
If the investors who interpret reported net income as good news (and hence have increased their expectations of future performance) outweigh those who interpret
it as bad news, we would expect to observe an increase in the market price of the firm's shares
Dramatic increase in volume during the week of release of earnings announcement
Finding the Market Response
Efficient market theory implies that the market will react quickly to new information
Important to know when the current year's reported net income first became publicly known
Earlier the observation, greater the effect between volume and price
The good or bad news in reported net income is usually evaluated relative to what investors expected
If the investors expectation resembles closely to the actual reported net income, the information content in reported net income is very low because the investor
would have to revise their prior beliefs (using the Bayes' Theorem for good/bad news)
If there is a discrepancy between expected and actual, the good or bad news would trigger rapid belief revision about the future performance of the firm
There are always many events taking place that affect a firm's share volume and price
A firm could have released its current year's net income, containing good news, on the same day the federal government first announced a substantial increase in the
deficit (bad news)
The effect on the share prices may show a downfall, largely due to the government announcement and not due to the current yea r's net income of the firm
It is important to separate the impacts of market-wide and firm-specific factors on share returns to avoid some a distortion between price and F/S information
Separating Market-Wide and Firm-Specific Factors
Actual return = R jt = [a j + B j R Mt + E jt]
Abnormal return (E jt) = actual return - expected return (a j + B j R Mt)
The error amount is an estimate of the abnormal, or firm specific, return on firm j's shares for that day
Can also be interpreted as the rate of return on firm j's shares for day t after removing the influence of market wide factors
Conceptually, if firm reports higher net income than expected by investors, logically the difference is due to firm specific factors, which is the error amount
Comparing Returns and Income
Recall expected return can be obtain from CAPM (a j + B j R Mt)
If unexpected net income is good news (a positive unexpected net income), then, given securities market efficiency, a positive abnormal share return constitutes evidence
that investors on average are reacting favorably to the unexpected good news in earning
E jt > 0 (good news)
If positive and negative abnormal returns surrounding good or bad earnings news are found to hold across a sample of firms, the researcher may conclude that predictions
based on the decision theory and efficient securities market theory are supported
Complications arise when there are multiple firm specific factors on the same day as earnings release, such as stock dividend
It is difficult to observe whether stock prices / market response reflected one or the other
Another complication is the estimation of firm's beta, which is needed to calculated expected return and to separate firm specific to market wide factors according to the
market model

Expected Market Reaction to Information

Higher trading volume
Adjustment in price
adjustment of the price if it's not what the investor is expecting
volume increase when investors have more information
if financial statement contain no new information, then we wouldn't be expecting any reactions
if it's new news (not expected), then there will be a reaction
Information Content of Earnings
Relative to market expectation
If actual earnings is different from expected earnings, there would be a reaction
Good estimation: past earnings, analyst estimation, how well the industry is doing; company guidance.
Measurement of Market Reaction
tend to focus on share price
change in price as a way measuring market reaction (share return)
worry about industry effects, the whole market effect (factoring into measurement)
when to worry about market reaction?
close to when announcement are done
Timing of Market Reaction
The earliest day when information is released

BALL AND BROWN RESEARCH STUDY

Research Question
does the firms' share returns respond to the information content of financial statements?
try to determine if security prices responded to financial statements
is information content in the accounting income number, does the market react to this accounting income number, assuming themarket is efficient (and information will
be used in pricing)
Design of Study

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 be used in pricing)
Design of Study
measure the information content of earnings (whether reported earnings were greater or less than the market had expected)
evaluate the market return on the shares of the sample firms near the time of each earning announcement
see good news and bad news and see how prices will react to it
actual more than expect (good news)
actual less than expect (bad news)
looked at earnings per share (expectation is last years earnings per share)
worked with monthly data
Results
the reason for the positive abnormal return was that investors were reacting favorably to the GN information in earning
Recall abnormal return > 0 is due to good news, < 0 is due to bad news
this pattern is repeated across the sample
the market did respond to the good or bad news in earnings during a narrow window consisting of the month earnings announcement is made
In the 11 months calculation, market began to anticipate the GN or BN as much as a year early, with the result that returns accumulated steadily over the period
BB estimated that, on average, 85%-90% of the information in annual earnings was already built into share price by the time annual earnings were announced
measured cumulative earnings of 12 months
for good news firms, there is a positive share return versus bad news firm of a negative share return; this tells us that stock market reacted when earnings were released
Market is quite sophisticated in how it uses information
Important distinction between narrow and wide window studies
in a narrow window, it can be argued that the accounting information is the cause of the market reaction (causation)
Reason is because during a narrow window there are relatively few firm specific events other than net income to affect share returns
in other words, a narrow-window association between security returns and accounting information suggests that accounting disclosures are the source of new
information to investors
in a wide window, prices lead earnings (association)
firms are doing well should have much of the effect on their share prices anticipated by the market before the GN appears in the financial statements
net income and returns are associated (it is the real economic performance of the firm that generates the association since both price (with lag) and net income
reflect real performance)
association between share returns and earnings increases as the window widens
as the window is widened the relative effect of lag decreases
in the months before the release of the firm's earning, there could have been other information about the firm, therefore we see a stead increase/decrease in the
share price upon the release of earning information
Most of the information in net income was anticipated prior to earnings announcement date, as a result it cannot be claimed that reported net income caused the
abnormal return during the periods leading up to the earnings announcement date
I.e., an investor, 3 months prior to earning release, might have used past financial statements and other available information to estimate the firms earning.
Then, on the earning release date, the investor may either be correct, thus no unexpected earnings, or he may revise his esti mate using Bayes' Theorem,
depending on GN (positive unexpected earnings) or BN (negative unexpected earnings) to derive a new probability and to calcul ate new expected earnings
In the long run, the total income earned by the firm will approach total income under ideal condition
In a narrow window, it provides stronger support for decision usefulness
Outcomes
Logical next step: whether the magnitude of unexpected earnings is related to the magnitude of the security market response
BCW found that the greater the change in unexpected earnings, the greater the security market response

EARNINGS RESPONSE COEFFICIENTS

An earnings response coefficient measures the extent of a securitys abnormal market return in response to the unexpected com ponent of reported earnings of the firm
issuing that security.
Trying to understand why the reaction differs across firms
For a company what is the return on its shares (factoring out market return) compared to accounting earnings of the firm (fac toring out the expected earnings)
How the unexpected earnings drive the abnormal share return
Shares should not change if the expected earnings and actual earnings are the same
ERC = abnormal share return / unexpected earnings for the period (result is abnormal return per dollar of abnormal earnings)
Abnormal share return does not equal abnormal earnings (net income)
Abnormal share return can be obtained from the Market Model
Unexpected earnings = Actual - Expected (accretion of discount)
Assume that abnormal share return and unexpected earnings does not change in proportions
ERC factors
Beta:
the demand for the GN firms share will be lower the higher is its beta (more risky)
lower demand implies a lower increase in market price and share return in response to the GN, a lower ERC
risk adverse investors have limited demand for risky investment
Capital structure:
for highly levered firms, the good news in earnings goes to the debt holders rather than the shareholders
the ERC for a highly levered firm should be lower than that of a firm with little or no debt, other things equal
the higher the debt equity ratio, the less the ERC
the higher the debt equity, that means more of earnings are going to debt holders and not shareholders and not available to shareholders
Earnings Quality:
the higher the probabilities of the main diagonal of the associated information system, the higher we would expect the ERC tobe
Higher quality earnings, it allows investor to infer future earnings
Two dimensions of earnings quality:
Earnings persistence
the ERC will be higher the more the good/bad new in current earning is expected to persist into the future, since current ear nings then provide a better
indication of future firm performance (earnings persistence)
persistence is measured as the extent o which earnings changes of the past two years continued into the current year
3 types of earning events
permanent, expected to persist indefinitely (ERC=(1+Rf)/Rf or 1+ 1/Rf)
Transitory, affect earnings in the current year only (ERC=1)
price-irrelevant, persistence 0 (ERC =0)
Rf is the risk free rate of interest under ideal condition)
when earnings persists beyond the current year, the magnitude of the ERC varies inversely with the interest rate
Accruals Quality:
Net income = Cash flow from operations + Net accruals
Net accruals include changes in non-cash working capital
To measure accrual quality, those accruals that are of high quality are to the extent of current period working capital accru als that show up as cash flows next
period
WC = b0 + b1CFOt-1+b2CFOt+b3CFOt+1+t
Earning quality is based on the variability of the t residuals, where high t variability indicates a poor match between current accruals WC and the subsequent
actual operating cash flow realization
The firms ERC and the share prices respond positively to accrual quality as measured by this procedure

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 The firms ERC and the share prices respond positively to accrual quality as measured by this procedure
The higher the accruals quality, the higher the ERC
This will lead to good cash flow in the future and will be earnings to the shareholders
Growth Opportunities:
The GN or BN in current earnings may suggest future growth prospects for the firm, and hence a higher ERC
Similarity of Investor Expectation:
the more similar the earnings expectations the greater the effect of a dollar of abnormal earnings on share the greater the ERC, other things equal
different investors will have different expectations of a firms next-period earnings, depending on their prior information and the extent of their abilities to evaluate
financial statement information
Informativeness of Price:
the more informative is price, the less will be the information content of current accounting earnings, other things equal, the lower the ERC

FINANCIAL REPORTING
Implications of ERC Research
Improved understanding of market response suggests ways that they can further improve the decision usefulness of financial statements
I.e., lower informativeness of price for smaller firms implies that expanded disclosure for these firms would be useful for investors, contrary to a common argument
that larger firms should have greater reporting responsibilities
For highly levered firms, ERCs are lower, thus to the extend that liabilities in this situation affects market's response to net income, then liabilities should be disclosed
Growth opportunities suggest to investors that the desirability of disclosure of segment information, since profitability information by segments would better enable
investors to isolate the profitable, and unprofitable, operations of the firm
Earnings persistence to the ERC means that disclosure of the components of net income is useful for investors
Role of Additional Information
Helpful in reducing inefficiencies in the market, thereby enabling securities market to work better
Accounts must ensure that unusual, non recurring items are fully disclosed, otherwise investors may overestimate the persistence of current reported earnings
Banking

ARTICLE 1: New Benchmarks Crop Up in Companies Financial Reports

Groupons IPO
Performance measure: adjusted consolidated segment net income
Average investors know what it is?
SEC wants everyone to have the same information as opposed to just some individuals
Is the information good or bad?

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