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LECTURE 9 – CAPITAL MARKETS RESEARCH AND ACCOUNTING  Final exam is closed book  Information will be provided regarding the final exam after the mid-semester break  Janet would really appreciate feedback through the LEX survey – particularly on the issues of assessment and content Capital Market Research and Accounting  Extensive research into capital markets  Seminal paper, Ball & Brown (1968) o They argued that Capital Theory provided justification for selecting the behaviour of security prices as an operational test of usefulness o The flow of information to the market would be reflected in security prices.  Be aware of the age of this research (45 years ago), when the information environment – access and speed was very different  There were a lot fewer companies around  Efficient market hypothesis o A market is efficient if security prices fully reflect all available information o Relies on the notion that people react rationally to information  Is the basis for all neo-empirical accounting research  This has occurred as a result of the Ball & Brown paper  There is a lot of research which rejects the efficient market hypothesis o Firms disclosure through annual reports  It relies on this being the primary disclosure mechanism – we now know there are many issues associated with the annual financial report  Accounting policy makers o Rely on the efficient market hypothesis when setting policy and standards o Market efficiency is being challenged o Findings of some capital market research is not strong and indicates that the market is not efficient  Findings are getting weaker over time as information becomes more available o Behavioural finance research contradicts the assumption that capital markets are efficient Research methods: event studies and associated studies  Event study o Change in level or variability of share price or trading volume  Focus on a specific announcement date or period at which earnings announcements are made  Looking for a change eg share price was $1.50 two days before announcement, announcement made and then the day after announcement share price is $1.60. This would prove that the information provided has utility – it is done many many times though on a large scale  Association study o Correlation between accounting performance measure and share returns What market response studies tell us  Event studies focus on earnings announcements  Disclosure of earnings • Capture information and result in adjustments  Association studies capture information reflected in share prices • However, the majority of information comes from non accounting information  Interim disclosure helps investors predict annual earnings • The release of a half yearly figure helps to predict annual earnings and their direction/magnitude of growth • If people are expecting growth, there may not be a move in share price • If people are not expecting growth, there may be a significant increase in share price • If people are not expecting a loss but it occurs, there may be a significant decrease in share price as a response to an unexpected announcement about profit Price Lead Earnings  Means that the information set reflected in prices contains information about future earnings o People have some idea over how the accounting firm is predicted to perform  Accounting ‘garbles’ an otherwise ‘true’ earnings signal about firm value o This occurs when Generally Agreed Accounting Principles (GAAP) are applied Post-earnings Announcement Drift  How quickly or not the market reacts to share price information  Kothari (2001) o Stock market underacts to earnings information  Evidence is inconsistent with the assumption of capital-market efficiency  The capital-market efficiency says the market should react quickly to information  This has accelerated the way in which people are seeking guidance over the use of accounting information  Post-earnings announcement drift o Finding that prices adjust gradually to new information o Studies cover inflation-adjusted earnings, residual earnings and operation cash flows as measures  Firms have moved away from using straight earnings information (ie. Profit) to include various measures of profit  When looking at long-term studies, people look at adjustments over time to account for the true value of the earnings  Residual earnings = different between actual and expected earnings  Firms typically use operation cash flow as a measure because cash flow is critical to the future existence of the business Association Studies  Regress accounting numbers on capital-market data to test the significant relationships o The reason for testing this is to assess value relevance  Value relevance o An item of accounting information that makes a difference to the decision made by users of financial statements  There is a significant amount of data collected around firms over a number of years in order to assess the significant relationships between the firms  This relationships will typically have control variables – distinguish between small and large firms/industries (mining industry reacts quicker than retail industry) which should be acknowledged  Ultimate goal is to achieve some notion of value relevance – if information conveyed changes an investors’ expectations about future returns and do people react differently to this? Four Different Associations  Earnings and security returns • Whether or not there exists a relationship between earnings and security returns • In theory, you would expect there would be as most people hold shares expecting a return on investment (this is reflected in share price)  The value relevance of nonearnings data • Evaluating share price in relation to non-earnings data (not necessarily non accounting information) – for example this may include the level of accruals (does this have value relevance and is it reflected in the share price?)  The value relevance of different accounting practices  The value relevance of different GAAP • Significant amount of research into both of these areas – particularly regarding the use of historical cost and fair value and the impact on share price. Is this value relevant information? Does accounting standards impact on share prices? Different Research Methods  Relative association studies o Stock market value or changes in those value  Incremental association studies o Accounting number of interest is helpful in explaining value or returns  Marginal information conten
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