3. Explain in your own words what post-announcement drift is.

why is this an anamoly for the securities market efficienvy? Does post-announcement drift necessarily imply that the average investor is not rational? - Post-announcement drift is the tendency for the share prices of firms that report GN or BN in quarterly earnings to drift upwards and downwards, respectively, for a lengthy period of time following the release of the earnings report. The reporting of, say, GN this quarter (compared with the same quarter last year) increases the probability of reporting GN next quarter as well. -This is an anomaly for efficient securities markets theory because, to the extent that the drift is not explained by barriers to arbitrage such as idiosyncratic risk or transactions costs, share prices should respond immediately to all the information content of earnings, according to the theory. However, this does not seem to happen. Instead, the market takes a lengthy period of time to figure this out -Depends. Irrational: On the one hand, it could be driven by behavioural biases such as conservatism or limited attention. Rational: On the other hand, it could be driven by the uncertainty of rational investors about whether the firms expected earning power has in fact increased (for GN) or decreased (for BN). Due to uncertainty, investors attach some probability to each possibility, and revise their probabilities over time as new evidence appears. These revisions will produce an upward or downward drift in share price over time. 4. Explain in your own words why the market response to accruals, as documented by Sloan (1996), is an anamoly for securities market efficiency? -In theory, The efficient market will respond more strongly to the GN or BN in earnings (i.e., a higher ERC) the greater is the persistence of the GN or BN. Cash flows are more persistent than accruals since the effects of accruals on current earnings reverse in future periods and requires more jusdgement, whereas (operating) cash flows are not subject to this reversal phenomenon. Sloan checked this argument for his sample firms and found that cash flows were indeed more persistent than accruals. This being the case, the efficient market will respond more strongly to a dollar of abnormal earnings if it comes from operating cash flows than if it comes from accruals (recall that net income equals operating cash flows plus or minus net accruals). Sloan found that while the market did respond to the GN or BN in earnings, it did not respond more strongly when there was a greater proportion of cash flows to accruals in earnings. This is an anomaly because a differential response is predicted by efficient securities market theory. 5. - According to rational single-person decision theory, the investor will prefer the first fund, since it has both a higher expected return and a lower risk.

According to prospect theory, however, investors will separately evaluate gains and losses on their investment prospects, and the rate of decrease of utility for small losses may be considerably greater than the rate of increase of utility from small gains. (investors are more loss averse) Since the second fund truncates the fund losses, this gives it an advantage over the first fund.

6. a. Earnings quality, also called informativeness of the information system, is the ability of current earnings to enable investors to infer future firm performance. It can be conceptualized by the main diagonal probabilities of the information system (Table 3-2). The higher the main diagonal probabilities relative to the off- main diagonal, the greater the quality. b. Except under ideal conditions, net income does not completely capture all events affecting firm value for the following reasons: Historical cost-based accounting, still a major component of the mixed measurement model, lags in recognizing many value-relevant events such as management changes, new processes and patents, discovery of natural resources, production of inventory, etc. Thus, there are many factors affecting share price that the efficient market will recognize prior to financial statement recognition. Consequently, investors may not give full attention to reported earnings, preferring to rely on more timely information sources. The informativeness of price, particularly for large firms. Other sources of information, such as the media, company announcements, quarterly reports, are often more timely than earnings. Thus, the market will anticipate much of the information content of net income, leaving less for the market to react to at the earnings release date. -The presence of liquidity or noise traders means that there are always random factors affecting share price. Net income would not be expected to explain these. Non-stationarity. Share price parameters such as beta may shift over time. This will affect share price but is not explained by net income. Non-rational investors. Investors subject to self-attribution bias may overreact to good news, leading to share price momentum, or underreact to bad news. Investors subject to limited attention may not process all available information. Both of these characteristics will reduce or delay share price reaction to net income. c. Increased use of a measurement perspective in financial statements will raise earnings quality if the resulting increase in relevance outweighs the decrease in reliability. Relevance increases because there is less of a lag between the occurrence and recognition of value-relevant events such as changes in fair values of investments, capital assets, changes in the present value of long-term debt, pensions, post-retirement benefits, etc. Reliability will not decrease providing fair values are based on well-working market prices. However, to the extent such market values are not available, greater use of measurement may decrease representational faithfulness and verifiability, and increase possibility of bias. If the effect on relevance is greater than the effect

on reliability, the main diagonal probabilities of the information system increase. That is, earnings quality increases. Then, we would see a larger response of security prices to the good or bad news in earnings (i.e., higher ERC).

7. From a single person decision theory perspective, reported earnings are value relevant if they lead to buy/sell decisions, caused by investors revising their beliefs about future firm performance, during a narrow window surrounding the date of release of the earnings information. Buy/sell decisions in turn lead to changes in share prices and returns. R2 measures value relevance of earnings information since it is the proportion of the variability of abnormal share return explained by the GN or BN in reported earnings during a narrow window surrounding the earnings release datethe higher is R2 the greater the value relevance of reported earnings since a greater proportion of the change in share price during the narrow window is then explained by the earnings information. ERC measures value relevance of earnings information since it is the amount of abnormal share return per dollar of earnings GN or BN. The higher is the ERC, the greater is the value relevance of reported earnings since a high ERC means that the earnings information has a high impact on investor buy/sell decisions. Note: The ERC is affected only by the reported earnings information. R2 can fall even if the effect of earnings information on share price holds steady or increases, since a decrease in R2 can also be due to the effects on investor decisions of an increase in the information provided by factors other than reported earnings. This other information would be captured by the residual term of the returns/earnings regression. In this scenario, the fall in R2 is due to more share price variability to be explained, rather than necessarily to a decrease in the quality of earnings per se. Yes, it is possible for R2 and ERC to fall but abnormal return to increase if other firm-specific factors accompany the earnings announcement. Abnormal return includes the effects of all firm-specific factors affecting share price, while R2 and ERC capture only the effects of reported earnings. Other firmspecific factors which may accompany the earnings announcement include announcements and forward-looking information from company officials, information on unusual and non-recurring events, analysts comments, and media articles. This information will also affect buy/sell decisions. Thus it will affect abnormal return even though it may not affect R2 or ERC. 10, PA = Bookvalue+ presentvalueof expectedfutureabnormalearnings 1 = 500 + (100 .14 500) /1.14 = 500 + 30/1.14 = $526.32 many ignores the fact that firm value consists of net assets as per the balance sheet plus the discounted present value of expected future abnormal earnings.

Failure to deduct a capital charge overstates firm value, since the market expects the firm to earn its cost of capital on opening investment, and only values the abnormal portion of future earnings. To put this another way, the $500 book value of the firms assets would have to be written down if they could not earn cost of capital, according to ceiling test standards.

Positive accting theory may imply that there could be indirect cash flow differentials that may afffect the opinoin of equity investors PAT helps us to predict Opt for shorter leases Opt for upfront purchase of assets

CHAPTER 7 Qn5 . Qn10. a. The increase in Ballards share price implies a low R2 and ERC. There was a positive firm-specific (i.e., abnormal) return on Ballards shares in response to the increase in its reported loss (i.e., a negative change in earnings). This implies a low ability of net income to explain the market response (i.e., low R2), and a negative ERC. Lev and Zarowin (LZ) argue that the primary reason for low R2 and ERC is failure to record the fair value of self-developed goodwill, such as that resulting from R&D. Capitalization of all or part of R&D costs would reduce Ballards reported loss and even result in positive earnings. This would increase the association (i.e., R2 and ERC) between the GN or BN in earnings and the market response. b. LZ suggest capitalization of accumulated R&D costs once they pass a hurdle that suggests a successful research project. The higher the hurdle, the higher the reliability of the capitalized R&D. Adoption of this suggestion would increase R2 and ERC. The mismatch between the timing of the costs and benefits of the R&D would be reduced. It is this mismatch, where the costs are charged to expense prior to the benefits that result that produces the

situation of Ballard Power. Under the LZ proposal, the market response to the successful R&D program and the GN or BN in reported earnings would take place at the same time, thereby increasing the association between share return and abnormal earnings. Of course, the association would not be complete, since research costs prior to feasibility would still be expensed, even though the market may regard them as having future value. A possible difficulty of reliable capitalization of R&D derives from the concept of a fully revealing separating equilibrium. To the extent that the market takes the large investment by Ballard in R&D as a signal of the firms research potential, share price gets an extra increase over and above the expected future profitability of the capitalized research itself. This encourages Ballard management to overinvest in R&D, leading to future share price decline as the market realizes the overinvestment. Relatively low reliability will reduce this effect, since the initial market overreaction is dampened. c. Ballards doubling of its R&D costs suggests (signals?) that it anticipates future success from its fuel cell technology. The market price of Ballards shares increased upon receipt of this information. This suggests securities market efficiency, since, despite an increased reported loss, the market has responded favourably to information that suggests increased probability of future R&D payoffs.