Financial Accounting Theory

Seventh Edition
William R. Scott

Chapter 5
The Information Approach to Decision
Usefulness
Chapter 5 The Value Relevance of Accounting Information
 5.1 The Value Relevance Approach

Assumes securities market efficiency

Investors responsible for predicting future firm performance
Role of financial reporting to provide useful information for this
purpose
Usefulness of financial statement information evaluated by
magnitude of security price response to that information
Helps accountants to evaluate decision usefulness of different
accounting policies
 5.2. Outline of the Research Problem

Reasons for market response

An application of decision theory model
Investors have prior probabilities of future firm performance
Investors obtain useful information from financial statements
Investors revise their probabilities
Leads to buy/sell decisions
Security price and share return change

>> Continued
 Outline of the Research Problem (continued)

Abnormal share return

Most value relevance studies examine effect of earnings information
on return on firms common shares
Total share return = return due to market-wide factors abnormal
return due to firm-specific factors
Abnormal share return can be attributed to financial accounting
information
If good news in financial statements leads to positive abnormal share
returns (and vice versa), conclude financial statement information is useful.
To reach such a conclusion, need to separate market-wide and firm-
specific share return

>> Continued
 Outline of the Research Problem (continued)

Separating market-wide and firm-specific returns

Firm releases financial information
Most studies look at release of earnings
Use a market model to estimate market-wide return on that day (or
narrow window)
Assumes market efficiency
Abnormal share return during narrow window = total return market-
wide return
See Figure 5.2

Continued
Outline of the Research Problem (continued)
 Outline of the Research Problem (continued)

Unexpected earnings
Investors have expectations of current earnings
Investors expectations are built into share price prior to release of
current earnings
Assumes market efficiency
When current earnings released, investors will react only to unexpected
component
Investors earnings expectations unobservable
How to estimate unexpected earnings?

>> Continued
 Outline of the Research Problem (continued)

Estimation of investors earnings expectations

Time series approach
Based on earnings in prior years
Analysts forecasts
Available for most large firms
Now the most common approach
 Outline of the Research Problem (continued)

Finally, compare abnormal share return with unexpected

earnings
If positive unexpected earnings is correlated with positive abnormal
share return, and vice versa, suggests earnings information is decision
useful
 5.3 The Ball and Brown Study

The first study to document statistically a share price

response to firm-specific component of reported net income
(1968)

Methodology still in use today

 The Ball and Brown Study (continued)

B&B methodology
For Each Sample Firm:
Estimate investors earnings expectations (proxied by last years actual)
Classify each firm as GN (actual earnings > expected earnings) or BN (vice
versa)
Estimate abnormal share return for month of release of earnings (month
0), using procedure of Figure 5.2

Continued
 The Ball and Brown Study (continued)

B&B methodology (continued)

Calculate Average Abnormal Share Return for GN Firms in the sample
for Month 0
Ditto for BN Firms
Repeat for Months -1, -2,,-11, and Months +1, +2,,+6
Plot Results
See Fig. 5.3, next slide
B&B Results
 The Ball and Brown Study (continued)

B&B conclusion
Stock market reacts to earnings information in month zero, but begins
to anticipate the GN or BN in earnings 12 months prior
Consistent with securities market efficiency and underlying rational
decision theory

>> Continued
 The Ball and Brown Study (continued)

Causation v. association
Narrow Window Studies
Evidence that financial statement information causes security price change
B&B month zero is narrow window
Wide Window Studies
Evidence that financial statement information is associated with security
price change
B&B months -12 to -1 and 1 to 6 are wide window
Narrow window studies more consistent with decision usefulness
>> Continued
 The Ball and Brown Study (continued)

Research in years following Ball & Brown

Does amount of abnormal share price change correlate with amount of
GN/BN in earnings?
Amount of GN/BN = expected earnings - actual earnings
Answer: Yes
With quarterly earnings reports? Yes
On other stock markets? Yes
 5.4 Earnings Response Coefficients

A different question
Does quality of earnings affect magnitude of abnormal share return?
Conceptually, quality of earnings is measured by the main diagonal
probabilities of the information system
Higher main diagonal probabilities implies higher quality
In practice, earnings quality often measured by:
Earnings persistence
higher persistence higher quality
Accruals quality
DeChow & Dichev (2002)): higher accruals quality higher earnings quality
 Definition of ERC

An earnings response coefficient (ERC) is

abnormal share return divided by unexpected
earnings
That is, ERC is abnormal share return per dollar of
unexpected earnings
Question then is
Does higher earnings quality result in higher ERC?
For earnings quality measured by persistence: Yes
For earnings quality measured by accruals quality: Yes

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 Earnings Response Coefficients (continued)

Characteristics affecting ERC

Risk (): higher lower ERC
Capital structure: higher D/E lower ERC
Earnings quality:
higher quality higher ERC
Important components of earnings quality
Earnings persistence:
higher persistence higher ERC
Accruals quality
DeChow & Dichev (2002)): higher accruals quality implies higher earnings quality

>> Continued
 Earnings Response Coefficients (continued)

Factors affecting ERC (continued)

Growth opportunities: higher opportunities, higher ERC
Similarity of investor expectations: more similar, higher ERC
Informativeness of price: more informative, lower ERC
Firm size as proxy?

>> Continued
 Reasons for Studying ERCs

ERC research has greatly improved accountants

understanding of how market responds to reported earnings
Better understanding enables preparation of more useful
financial statements
E.g., Financial reporting policies that produce a higher ERC are more
decision useful for investors

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5.4.3 Measuring Investors Earnings Expectations

Time series approach

Depends on earnings persistence
Earnings 100% persistent
Unexpected earnings = change in earnings
Earnings zero persistence
Unexpected earnings = current years earnings
Analysts forecasts approach
Evidence suggests more accurate than time series
Unexpected earnings = analyst forecast error
Older forecasts tend to be less accurate
Are analysts biased?

5 - 23
A Caveat about the Best Accounting Policy (continued)

While accounting policies that produce the highest ERC may

be most decision useful for investors, they may not be best
for society
Accounting information as a public good
Investors who do not pay for accounting information will demand
more of it than socially desirable
Implication is that standard setters cannot be sure that an accounting
policy that has a higher ERC than another is socially better.
Complicates standard setting
5.6 Value Relevance of Other Financial
Statement Information
Balance sheet
Hard to find since more difficult to know when investors first become
aware of B/S information

Supplementary information
RRA: mixed evidence
Financial statement notes
Evidence of market response following the date firms report to SEC
Response driven by financial analysts who pounce on the data
MD&A:
Li (2010), Section 3.6.4
Brown & Tucker (2011), Section 3.6.4

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 5.7 Conclusion

Security market response to accounting information supports

rational decision theory and efficient securities market theory