Deegan fat4e ppt_ch10

10-1
Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd
PPTs to accompany Deegan, Financial Accounting Theory 4e
FINANCIAL ACCOUNTING THEORY
Craig Deegan
Slides written by Craig Deegan
CHAPTER 10
Reactions of capital markets to
financial reporting

10-2
Learning objectives
10.1 Understand the role of capital markets research in
assessing the information content of accounting disclosures.
10.2 Understand the difference between capital markets research
(which explores the response of ‘the market’ in aggregate)
and behavioural research (which explores the actions of
individuals).
10.3 Understand the assumptions of market efficiency typically
adopted in capital markets research.
10.4 Understand the basics of the ‘market model’ as derived
from the capital assets pricing model.
10.5 Understand the difference between capital markets
research that looks at the information content of accounting
disclosures, and capital markets research that uses share
price data as a benchmark for evaluating accounting
disclosures.
continued

10-3
Learning objectives (cont.)
10.6 Understand how, and why, some researchers use market-
based data (such as share prices and share returns) to
evaluate the ‘value relevance’ of accounting-based
information.
10.7 Be able to explain why unexpected accounting earnings and
abnormal share price returns are expected to be related.
10.8 Be able to outline the major results of capital markets
research into financial accounting and disclosure.
10.9 Be aware of debates that challenge long-held beliefs about
‘market efficiency’.

10-4
Capital market research—
introduction
• Explores the role of accounting and other financial
information in equity markets
• Involves examining statistical relations between
financial information and share prices
• Reactions of investors evident from capital market
transactions
• No share price change implies no reaction to
particular information – that there is no information
content

10-5
Capital market versus
behavioural research
• Capital market research (the topic of this lecture)
– assesses the aggregate effect of financial reporting on
investors
– considers only investors
• Behavioural research (the topic of the next lecture),
by contrast:
– analyses individual responses to financial reporting
– examines decision-making by many groups
 e.g. bank managers, loan officers, auditors

10-6
Reasons for capital market
research
• Information about earnings and its components
is the primary purpose of financial reporting. As
the IASB Conceptual Framework states:
– The objective of general purpose financial
reporting is to provide financial information
about the reporting entity that is useful to
existing and potential investors, lenders and
other creditors in making decisions about
providing resources to the entity.
continued

10-7
Reasons for capital market research
(cont.)
• The use of accounting information by investors is
therefore of central importance to the accounting
profession, in particular, the issue of whether accounting
information is used by investors in their decision making
processes
– capital markets research explores the market’s (investors in
aggregate) reaction to various releases of information –
including accounting information – and therefore capital
markets research should be of interest to the accounting
profession
• Earnings is the number most analysed and forecast by
security analysts
• Reliable data on earnings is readily available

10-8
So…the questions often asked by
capital markets researchers are…
• What is the impact of the release of
accounting information on share
returns?
• Which accounting information is
relevant for valuing shares in a
company?

10-9
Underlying assumption of CMR
—EMH
• CMR relies on the assumption that equity markets
are efficient
– in accordance with Efficient Market Hypothesis (EMH)
• Efficient market defined as a market that adjusts
rapidly to fully impound information into share prices
when the information is released

10-10
Three forms of market
efficiency
• Weak form prices reflect information about past
prices and trading volumes
• Semi-strong form all publicly available information
is rapidly and fully impounded into share prices in an
unbiased manner when released
– most relevant for accounting-based capital market research
• Strong form security prices reflect all information
(public and private)

10-11
Assumptions about market efficiency
• Any assumptions about market efficiency are simply that –
assumptions that are used within a model – and as we have
emphasised throughout this course/subject, models or theories will
not always fully reflect what actually happens in the ‘real world’.
– indeed, there have been many researchers who have rejected claims
that securities markets are efficient
• Assumptions about market efficiency have implications for
accounting.
– if markets are efficient, they will use information from various sources
when predicting future earnings, and hence when determining current
share prices
– if accounting information does not impact on share prices, then,
assuming semi-strong-form efficiency, it would be deemed not to
provide any information over and above that currently available
– at the extreme, accounting’s survival would be threatened

10-12
Market efficiency—
implications for accounting
• If markets are efficient they will use information
from various sources when predicting future
earnings
• If accounting information does not impact on share
prices then it is deemed not to have any
information value above that currently available

10-13
Market efficiency – share prices react
to information from various sources
• For example, material provided within the textbook
indicates that share prices have been found to react not
only to earnings data but also to such things as:
– news about senior executive resignations
– takeover rumours posted to internet discussion sites
 which raises possible issues about the regulation of information
provided on such sites
– concerns raised by auditors, particularly in relation to going
concern considerations (unless anticipated by the market)
– industry-wide changes, such as the implications associated
with the introduction of particular legislations (such as the
Sarbanes-Oxley Act in the US)
continued

10-14
Share prices react to information from
various sources (cont.)
• Again, a share price reaction indicates that the ‘news’ has
‘information content’
– But remember, the information might later prove to be either
correct or incorrect (something that becomes known with
hindsight)
• Conversely, no share price reaction indicates that the
news or event did not act to cause the market to revise
any previous expectations held about a firm’s future cash
flows
– the absence of share price movement indicates either that
the information is irrelevant or that it confirms market
expectations

10-15
Event studies
• Studies which look at the changes in share prices around a
particular event, such as the release of accounting information,
are often referred to as ‘events studies’.
• According to Kothari (2001):
– in an event study, one infers whether an event, such as an earnings
announcement, conveys new information to market participants as
reflected in changes in the level or variability of security prices or
trading volume over a short time period around the event
– if the level or variability of prices changes around the event date,
then the conclusion is that the accounting event conveys new
information about the amount, timing, and/or uncertainty of future
cash flows that revised the market’s previous expectations
– the maintained hypothesis in an event study is that capital markets
are informationally efficient in the sense that security prices are
quick to reflect the newly arrived information

10-16
Confounding events
• Within event studies there is typically a risk of ‘confounding
events’
• It should be noted that across time there will be many events
that will affect share prices and trading volumes
• One of the difficult tasks in undertaking ‘event studies’ that
review share price reactions to particular announcements is to
try to ensure that there have been no other (confounding)
events around the same time which might also have influenced
share prices
• For example, if accounting profits are announced on the same
day that the chief executive officer has resigned then it would
be difficult to determine what caused any possible share price
reaction – was it the profits, or the resignation?

10-17
Earnings/return relation
• Share prices are the sum of expected future cash
flows from dividends, discounted to their present
value using a rate of return commensurate with the
company’s risk
• Dividends are a function of accounting earnings
• Unexpected earnings rather than total earnings
expected to be associated with a change in share
price

10-18
Earnings/return relation—the
market model
• Used to separate out firm-specific share price
movements from market-wide movements
– derived from the Capital Asset Pricing Model
• Assumes investors are risk averse and have
homogeneous expectations
• Its use allows the researcher to focus on share price
movements due to firm-specific news
continued

10-19
Earnings/return relation—market
model (cont.)
• Total or actual returns can be divided into
– normal (expected) returns given market-wide movements
– abnormal (unexpected) returns due to firm-specific share
price movements
• Abnormal returns used as an indicator of
information content of announcements

10-20
the relationship between changes in
share price and returns to investors
• The previous slide referred to share ‘returns’
• Returns (to shareholders) are a function of share price
Return = End Price + Dividends – Beginning price
Beginning price
• Returns are generally calculated over periods of between
one day and one year
• If no dividend is paid, returns are simply equal to
percentage change in price
– e.g. if a company’s share price increased from $5.42 to
$5.56 during the day when earnings were announced,
the daily return is:
(RCMR) = (5.56 – 5.42)/5.42 or 2.6%

10-21
The Market Model
Raw return
on day t
Constant
average
daily return
Return due to
market moves
Return due
to firm moves
(Firm specific
news)
= + +
Rit = αi + bi(Rmt) + µit
Actual returns = Normal returns + Abnormal returns
continued

10-22
The Market Model (cont.)
• Estimates of αi and βi are calculated as a result of using
ordinary least-squares regression (or the generalised least
squares-approach) which utilises historical data and many
observations about a firm’s returns and the market’s
returns
• For the market model, it is assumed that the market model
parameters are consistent throughout the period of
analysis and that the variations in returns on individual
securities are largely due to market-wide factors
• As a portfolio of investments increases in diversity, the
non-systematic risk of the diversified portfolio (measured
by αit + µit) tends to disappear, thereby leaving only returns
that are due to market-wide movements (that is, βitRmt)

10-23
Diagrammatic representation
of the market model

10-24
Results of CMR—Ball and
Brown (1968) study
• One of the most highly cited papers in the accounting
literature
• Examined data from 261 US firms
• Tested whether firms with unexpected increases in
accounting earnings had positive abnormal returns, and
firms with unexpected decreases had negative abnormal
returns
• Found that:
– information contained in the annual report, prepared using
historical cost was useful to investors
– 85 to 90% of earnings announcement is anticipated by
investors
– much of information is obtained from other sources

10-25
Ball and Brown (1968)

10-26
Results of CMR—extent of
alternative information
sources
• Information content varies between countries and
companies
• Compared to US markets, Australian market had slower
adjustments during the year with larger adjustments at
earnings announcement
– less alternative sources of information for Australian market
• Less alternative sources of information for smaller firms
than larger firms

10-27
Results of CMR—permanent
and temporary changes
• Research examined relationship between the
magnitude of unexpected changes in earnings
(EPS) and magnitude of abnormal returns
– known as the earnings response coefficient
– some research has shown that a 1% unexpected change
in earnings associated with 0.1 to 0.15% abnormal return
– depends on whether earnings increases expected to be
permanent or temporary

10-28
Results of CMR—relative
magnitudes of cash and
accruals
• Earnings persistence depends on proportion of
accruals relative to cash flows
– firms with large accruals relative to actual cash flows
unlikely to have persistently high earnings
• Share prices found to act as if investors ‘fixate’ on
reported earnings without considering relative
magnitudes of cash and accrual components

10-29
Results of CMR—information
announcements of other firms
• Earnings announcements by one firm also results in abnormal
returns to other firms in the same industry
– known as ‘information transfer’ effect
• Related to whether the news reflects a change in conditions for
the entire industry, or changes in relative market share within
the industry
• For example, if an organisation within an industry is the first to
prepare its financial results for the year, and it reports record
profits (lower profits) that were unexpected by the market, then
this would often cause share price increases (decreases)
across the industry
– for example, Accounting Headline 10.7 shows that when Target
reported a lower than expected earnings forecast it sparked
declines in the share prices of other retail organisations

10-30
Results of CMR—information
content of earnings forecasts
• Announcements of expected earnings rather than
actual earnings are associated with share returns
• Management and security analysts both make
forecasts

10-31
Results of CMR—benefits of
voluntary disclosure
• Voluntary disclosures include those in annual reports
as well as media releases etc.
• Firms with more disclosure policies have
– larger analyst following and more accurate analyst earnings
forecasts
– increased investor following
– reduced information asymmetry
– reduced costs of equity capital

10-32
Results of CMR—recognition
versus footnote disclosure
• Recognising an item in the financial statements is
perceived differently to disclosure in footnotes
• Investors place greater reliance on recognised
amounts than on disclosed amounts

10-33
Results of CMR—size
• Relationship between earnings announcements
and share price movements is inversely related to
the size of the entity
• Earnings announcements found to have a greater
impact on share prices of smaller firms than larger
firms
• More information generally available for larger firms

10-34
Results of CMR—unexpected changes in
earnings vs unexpected changes in expenses
• If ‘earnings surprises’ are accompanied by revenue
surprises of similar magnitude in the same direction,
then the earnings surprises are driven by revenue
growth rather than by a reduction in expenses
• Researchers expect earnings growth driven by
revenue growth to exhibit a different level of
persistence compared with earnings growth driven
by expense reduction
• Jegadeesh and Livnat's (2006) results indicate that
the market does tend to react more to unexpected
earnings when these 'surprises' are due to increases
in revenues

10-35
Do current prices anticipate
future announcements?
• As firm size increases, share prices incorporate
information from wider number of sources
– relatively less unexpected information when earnings are
announced
• May be able to argue that share prices anticipate
future earnings announcements for larger firms with
some accuracy

10-36
Accounting earnings reflecting
information (value relevance research)
• Rather than determining whether earnings
announcements provide information, recent research
also examines whether earnings announcements
reflect information that has been already used by
investors
– ‘looking back the other way’
– market prices viewed as leading accounting earnings
continued

10-37
information (cont.)
• Share prices are considered as benchmark
measures of firm value
• Share returns are considered as benchmark
measures of firm performance
• Benchmarks are then used to compare usefulness of
alternative accounting and disclosure methods
• Based on premise that market values and book
values are both measures of firm value
continued

10-38
information (cont.)
• If market value is related to book value, returns
should be related to accounting earnings per share,
divided by price at the beginning of the accounting
period
– provides an underlying reason why we should expect
returns to be related to earnings over time

10-39
Results of CMR—accounting
earnings reflecting information
• Beaver, Lambert and Morse (1980) found share
prices and related returns were related to accounting
earnings
• Because of various information sources, price
appeared to anticipate future accounting earnings
• Supported by Beaver, Lambert and Ryan (1987)
continued

10-40
Results of CMR—accounting earnings
reflecting information (cont.)
• Dechow (1994) found over short intervals earnings
are more strongly associated with returns than are
realised cash flows
– the ability of cash flows to measure firm performance
increases as the measurement interval increases
continued

10-41
Results of CMR —accounting earnings
reflecting information (cont.)
• Studies examining which asset value approaches
provide accounting figures that best reflect market
valuation found:
– fair value estimates of bank’s financial instruments seem to
provide a better explanation of bank share prices than
historical cost (Barth, Beaver & Landsman 1996)
– revaluation of assets results in better alignment of market
and book values (Easton, Eddy & Harris 1993)

10-42
Relaxing assumptions about
market efficiency
• Recent years have seen a number of researchers
questioning some assumptions about market
efficiency
• Market reactions to information often found to be
longer than would be anticipated from an ‘efficient
market’. Also market found to sometimes ‘under-
react’ to particular announcements
• Created new areas for research—for example what
factors influence ‘earnings drift’
• So, should we reject research that has embraced the
EMH?

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