Chapter 8

Usefulness of Accounting Information to Investors and Creditors

Lecture
Earnings, Dividends, and Stock Prices Residual Income Models Risk and Return
Efficient-Markets Hypothesis Capital Markets Research in Accounting

Value of Accounting Information

Evidence from Return Data Evidence from Direct Valuation

Accounting data and creditors Earnings Forecasting Empirical Research and Standard Setting

Earnings, Dividends, and Stock Prices

Stock price is equal to the present value (capitalized value) of future expected earnings, adjusted by the dividend payout ratio. Current income has value in predicting future dividends via its value to predict future earnings.

From Earnings to Stock Prices

Miller and Modigliani (1961)
argue that dividend policy is irrelevant to firm valuation. show that the value of the firm is equal to the present value of future expected net cash flows. define net cash flows per period as operating cash flow minus cash investment in assets (the same definition as that used for capital budgeting analysis).

The attractiveness of the cash flow valuation model for accounting is that it maps directly onto the accounting system.

Residual Income Models

Residual Income (RI) is a general term for income in excess of a charge for the capital that is employed to generate that income. When applied to the enterprises operating income and invested capital, since the early 1990s, residual income has come to be called economic profit or Economic Value Added (EVA).

Economic Profit
Economic profit (EP) starts with the amount of capital that is invested at the beginning of the period. EP = NOPAT capital charge EP = NOPAT (WACC)(invested capital)

Residual Income is
an accounting measure and can, therefore, be manipulated for any one period. an income-based compensation system that provides an incentive for the management to allocate capital efficiently over time. is dependent on an accurate estimate of the cost of capital, no simple task.

Residual Income is
not economic income, despite the name given to some forms of residual income. A firms economic income is equal to net cash flows plus a change in present value or market value of the firm. surprisingly, not as strongly correlated with the total return to shareholders as one would expect.

Risk and Return

Efficient-Markets Hypothesis (EMH) Portfolio Diversification Capital Asset Pricing Model (CAPM)

Efficient-Markets Hypothesis (EMH)

Information content: when an item of information causes a price response in the security Three forms
Weak Semistrong Strong

Price/Share

Time

Portfolio Theory
Risk can be reduced by holding a portfolio of investments Risk types
Unsystematic (diversifiable) Systematic (undiversifiable)

Portfolio Diversification
Portfolio Risk (standard deviation)

Number of Securities

Capital Asset pricing Model (CAPM)

Theoretical pricing of stocks Market assumed to be a diversified portfolio Correlation made between returns on individual stocks and market returns Regression analysis fits a line to the scattergraph Slope of the characteristic line is beta

Value of Accounting Information

Information Contents of Earnings Announcements Market Reaction to Alternative Accounting Policies Accounting Alternatives and Cash Flow The Incomplete Revelation Hypothesis

Information Content of Earnings Announcements

+ Return on Stock

Return on Market

Characteristic Line -

Rj = i + Bj (Rm i)
Rj i
Rm

= expected return on security j = risk-free rate of return

= expected return on the market portfolio

Bj

= beta coefficient for security j

Empirical studies in accounting use an approach referred to as the market model

Rj = aj + Bj (Rm) + ej
aj
ej

= the intercept from the regression

= random error term

Unexpected or Abnormal Returns

Captured in the error term ej A common research approach is to regress these abnormal returns on accounting variables such as unexpected reported earnings for the same time period to determine if there is information content

Market Reaction to Alternative Accounting Policies Research has found that security prices respond to accounting income numbers. Alternative accounting methods affect reported earnings; however, there is no systematic effect on company cash flows. Accounting alternatives simply represent different patterns of expense recognition or cost allocations.

Accounting Alternatives and Cash Flow

Accounting policy changes with no apparent underlying changes in cash flow have no information content. LIFO, a choice with cash flow consequences in the USA, may have information content (studies mixed over the years). More recent security-price research has led to indirect consequences studies.

Anomalies
Fundamental analysis, study by Ou and Penman Low Correlation between Earnings and Stock Returns, study by Lev Post-Earnings-Announcement Drift, multiple studies Mispricing Related to Accruals, study by Richardson, Sloan, Soliman, and Tuna

Incomplete Revelation Hypothesis

Difficult to extract disclosure
some accounting numbers or relationships are more difficult or costly to uncover and their effects may not be fully revealed in security prices This is contrary to the EMH assumption

Noise traders
individuals who do not necessarily respond in a completely rational way in terms of responding to new information in terms of their trading habits may be rebalancing their portfolios, responding to liquidity shocks or even acting upon whims

Summary of the relationship between accounting data and unexpected changes in stock prices, measured as abnormal returns
Accounting earnings appear to have information content and to affect security prices Alternative accounting policies with no apparent cash flow consequences have no information content Alternative accounting policies with cash flow consequences do have information content Security markets do not react fully and instantaneously to certain types of accounting data in certain situations (e.g., high accruals, small stocks, low analyst coverage) There are incentives to choose certain accounting policies, where choice exists, owing to indirect cash consequences. Accounting-based risk measures correlate with market risk measures, suggesting that accounting numbers are useful for risk assessment.

Another research approach

Examine the association between accounting data reported in the financial statements and the levels of stock prices (not the abnormal returns) Referred to as cross-sectional valuation

Value of Accounting Information: Evidence from Cross-Sectional Valuation

Pensions, a firms pension plan assets and liabilities (as reported off-balance sheet in footnote disclosures) are consistent with their being viewed as on-balance sheet assets and liabilities, respectively Research & Development, the market interprets R&D as an asset (investment) rather than an expense Financial Services, banks supplemental disclosure of the fair market value of investment securities is associated with market value over and above that explained by historical costs alone.

Accounting Data and Creditors

Predicting corporate bankruptcy (loan default) Credit ratings, including bond ratings and default risk premiums Sensitivity of loan-related decision making to key accounting data, experimental studies support

Earnings Forecasting
While the value of the firm is equal to the present value of the future expected cash flows, earnings appear to play an important role in predicting those cash flows. Over the years, the relationship between earnings and stock prices has diminished.
However, the ability of earnings to forecast future cash flows has not. Kim and Kross examine the ability of earnings to forecast one-year ahead operating cash flows by examining three decades of data (1972-2001). Their findings are positive

Empirical Research and Standard Setting Can empirical research aid standard setting?
Holthausen and Watts say no Barth, Beaver, and Landsman say yes

The difference between the two positions involves an empirical issue, which is presently unresolved: the multiple user group problem

Lecture Recap
Earnings, Dividends, and Stock Prices Residual Income Models Risk and Return
Efficient-Markets Hypothesis Capital Markets Research in Accounting

Value of Accounting Information

Evidence from Return Data Evidence from Direct Valuation

Accounting data and creditors Earnings Forecasting Empirical Research and Standard Setting