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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