Decision Usefulness Approach to Financial Reporting

Week 9 Fauziah Md. Taib

OverviewofCapitalMarket Research
Explorestheroleofaccountingandotherfinancial informationinequitymarkets. Ofteninvolvesexaminingstatisticalrelations betweenfinancialinformationandsharepriceor returns. Favourable/unfavourablereactionsareevidenced bypriceincrease/decreaseintheparticular security. Conclusionsaremadeaboutthemarketsreaction toparticularinformationreleasesorevents,which determineiftheinformationwasrelevantand usefulforinvestmentdecisionmaking.

CapitalMarketResearch
Assessestheaggregateeffect offinancialreporting, particularlythereportingofaccountingearnings,on investors. Byanalysing sharepricereactionstofinancial informationreleases,thesumofindividualinvestor decisionsiscapturedinaggregate. Questionsthatareofinterest:
Isthatparticularinformationuseful? Isthatparticularinformationrelevanttoinvestors?

CapitalMarketResearch Assumptions
Equitymarketsareefficient
Marketadjustsrapidlytoimpoundfully informationintosharepriceswhenthe informationisreleased. Assumesthatmarketsaresemistrongform efficient.
Allpubliclyavailableinformation(includingthose availableinfinancialstatementsandotherfinancial disclosures)is rapidlyandfullyimpoundedintoshare pricesinanunbiasedmannerasitisreleased.

Whyassumemarketisefficient?
Unlesssuchanassumptionisaccepted,itis hardtojustifyeffortstolinksecurityprice movementstoinformationreleases. Ifthatparticularinformationleadstoaprice change,thentheinformationwasuseful and causedinvestorstorevisetheirexpectations aboutfutureearnings.
P0 =FutureExpectedCashFlow

Implicationsoftheassumption
Ifmarketsareefficient,investorswilluse informationfromvarioussourceswhenpredicting futureearnings,hencedeterminingcurrentshare prices. Ifaccountinginformationdoesnotimpactonshare pricesthen,itdoesnotprovideanyinformation overandabovethatcurrentlyavailable.
Ifthereissharepricereaction,thefinancialinformationis deemedtohaveinformationcontent.

WhyDecisionUsefulnessis Important?
Itisoftenarguedthat:
Moreinformedchoices betweenaccounting anddisclosurealternatives canbemadeif theexpectedimpactsonsharepricesare anticipatedwhenmakingfinancial reportingdecisions.

BallandBrown(1968)
Firstmajorcapitalmarketresearchpublicationin accounting,investigatedtheusefulnessof accountingearningsunderahistoricalcostmodel. Prior totheirresearch,itwaswidelyviewedthat historicalcostaccounting methodsresultedin meaningless informationthatwasnotusefulfor investorsandotherusersoffinancialstatements. Theirstudyfoundevidencethatsuggestthe informationcontainedintheannualreportisusedin investmentdecisionmaking,despitethelimitations ofthehistoricalcostaccountingsystems.

OtherFindingsbyResearchin CapitalMarket.
Priortoanearningsrelease,investorsobtain muchoftheinformationtheyneedfrom othersources(BallandBrown,1968). Informationcontentofearnings[ICoE] announcementsdependsontheextentof alternativesourcesofinformation.
ICoE variesbetweencountriesandbetween companieswithinacountry(Brown,1970).E.g. Differentspeedofsharepriceadjustment betweenUSandAustralianmarkets.

OtherFindingsbyResearchin CapitalMarket.
Therearebenefitsassociatedwiththevoluntary disclosureofinformation[LangandLundholm, 1996]. Recognitionisperceiveddifferentlytomerefootnote disclosure. Size
Earningsannouncementshavebeenfoundgenerallyto haveagreaterimpact onthesharepricesofsmallerfirms relativetolargerfirms[Freeman,1987]

ImplicationsofEfficientSecurities MarketforFinancialReporting
Beaver,W.H.,(1973),Whatshouldbethe FASBs Objectives?,TheJournalof Accountancy,(August,1973),pp.4956. Amongtheimplicationsmentioned:
1) Accountingpoliciesadoptedbyfirmsdonot affecttheirsecurityprices,aslongasnocash floweffects,policiesusedaredisclosed,and sufficientinformationisgiven. Efficientmarketisnotfooled bydiffering accountingchoices

ImplicationsofEfficientSecurities Market(Beaver,1973)
2) EfficientSecuritiesmarketgohandinhand withfulldisclosure.
Aslongasbenefitsexceedthecosts,firms shoulddiscloseontimelybasis Reason:Investorsuseallavailable,relevant informationtoimprovepredictionsofreturns. Asmoreinformationismadeavailable, investors confidenceinthemarketisenhanced.

ImplicationsofEfficientSecurities Market(Beaver,1973)
3) Marketefficiencyimpliesthatfirmsshouldnotbe overlyconcernedwithnaveinvestors.
Financialstatementsneednotbepresentedinasimple manner.Solongthereisenoughinvestorswho understandthedisclosedinformation,thepricewill movetowardsitsefficientlevel. Naveinvestorscanhireprofessionalstointerpretfor themorcanmimicthebuyandselldecisionofmore knowledgeableinvestors. Investorsarebeingpriceprotectedbytheefficient market.

FinalImplications (Beaver,1973)
4) Accountantsareincompetitionwithother informationproviders(financialanalysts, media,companyofficials,etc.).
Ifaccountantsdonotprovideuseful,cost effectiveinformation,theusefulness of accountinginformationwilldecline,hence, accountantscannotsurviveinthemarketplace.