Investigates connection between accounting information and share prices
Uses positive theories from finance
needed two tools from finance
EMH - is the prevailing paradigm in finance theory
Market model (based on CAPM)
Returns are also a function of earnings because
Share price is a function of expected future earnings & returns are a function of share price (capital gain or loss)
i.e. Return = end price – begin price / begin price (without divs)
Abnormal returns are the focus of capital market researchers
These firm specific share price movements are analysed to determine the information content of company announcements
There is ‘information content’ in earnings announcements where earnings are calculated using historical cost accounting methods
Historical cost income was used by investors in making investment decisions.
Firms with unexpected increases in earnings experienced positive abnormal returns during the month of the announcement (at point zero the time of the event) while firms with unexpected decreases in earnings experienced negative abnormal returns in the month of the announcement
Unexpected Earnings announcements and abnormal returns are positively correlated in terms of direction
Prior to earnings announcements, investors obtain much of the information they need from other sources
Most of the information contained in the earnings announcement (85 – 90%) was anticipated by investors
Refer to the graph and note the gradual slope in the lines in the 12 months leading up to the announcement.
This indicates that investors anticipated 85 – 90% of the information contained in the earnings announcement prior to its release.
Announcements normally occur several months after balance date
Accounting information contained in earnings announcements is only one of many sources utilised by the stock market