Final Paper - Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla,
•Chapter 5 – Value Relevance of Accounting Information Chapter 4 – Efficient Securities Markets Recap •Security prices correctly reflect publicly available information •Full disclosure of accounting policies is required to allow users to compare firms and interpret financial results Chapter 5 – Value Relevance of Accounting Information •How can we determine if investors / users are in fact acting rationally and markets are efficient? –Ball & Brown study performed in 1968 looked at value relevance •Value relevance = accounting information has "value relevance" when security prices respond to the information released. Chapter 5 – Value Relevance of Accounting Information •Usefulness of financial statement information evaluated by magnitude of security price response to that information •Information is useful if it changes users probabilities of outcomes (expectation of good financial results or poor financial results) •Information leads to changed probabilities, and therefore buy/sell decisions •Security price and share return change based on buy/sell decisions Chapter 5 – Value Relevance of Accounting Information •Abnormal share return –To t a l 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 Ball & Brown Study •B&B methodology –For Each Sample Firm: •Estimate investors’ earnings expectations (proxied by last year ’s actual) •Classify each firm as GN (actual earnings > expected earnings) or BN (vice versa) •Estimate abnormal sharereturn for month of release of earnings (month 0), using procedure of Figure 5.2 Ball & Brown Findings Ball & Brown Conclusions •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 Earnings Response Coefficients (ERC) •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 Recap ‐Single Person Decision Theory Information System for Decision Theory Given future Current period financial profitability is: statements will show:
Good news Bad news High .80 .20 Low .10 .90 •If these probabilities provide additional information about future profitability, users will be able to update their expectations. ERC vs. Ball & Brown •Ball & Brown looked at the direction of the reaction (good news vs. bad news) and direction of the stock price (price increase or decrease) •Earnings Response Coefficient (ERC) looks at the magnitude of the change vs. amount of new informaiton Earnings Response Coefficient ‐ERC •Other factors impacting ERC –firm specific risk – measured by beta –Capital structure: higher D/E lower ERC –Growth opportunities: higher opportunities, higher ERC –Earnings quality / Earnings persistence – higher earnings quality, higher ERC –Consistency of analysts expectation – higher ERC Implications of ERC Research •Improved understanding of market response to accounting information suggests ways to improve the decision usefulness of financial statements. –Eg. there is evidence that there is a positive relationship between ERC and earnings quality, suggests that earnings quality is valued by equity investors –Eg. ERC is lower for highly leveraged firms suggests that full disclosure of liabilities (on and off balance sheet) is required Implications of ERC Research •Importance of earnings persistence to ERC means that disclosure of the components of net income is useful for investors –detail, disclosure, supplemental information –consider "extraordinary items" •Recap Ball & Brown •Chapter 5 Ball & Brown Study •B&B methodology –For Each Sample Firm: •Estimate investors’ earnings expectations (proxied by last year ’s actual) •Classify each firm as GN (actual earnings > expected earnings) or BN (vice versa) •Estimate abnormal sharereturn for month of release of earnings (month 0), using procedure of Figure 5.2 Ball & Brown Findings Ball & Brown Conclusions •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 ERC vs. Ball & Brown •Ball & Brown looked at the direction of the reaction (good news vs. bad news) and direction of the stock price (price increase or decrease) •ERC looks at the magnitude of the change vs. amount of new informaiton Group Discussion #1 •Explain what is meant by the value relevance of accounting information. Does it rely on the historical cost basis of accounting? Group Discussion #2 •IAS recognizes the need for full disclosure of the components of reported net income. Explain why full disclosure of net income components is important if investors are to properly interpret the implications of current reported net income for future firm performance. Group Discussion #3 •What is classification shifting? Why does classification shifting make it more difficult for investors to predict future firm performance from current reported net income? How could the problem of classification shifting be reduced? Ball & Brown Question •PA R T A: The findings of Ball and Brown (1968), as depicted in the following graph, provide various insights. What on their graph supported their main finding that the market reacts efficiently to earnings announcements? •PA R T B: Describe what on their graph suggests that the market is INEFFICIENT? Why? •PA R T C: If a well‐conducted study finds that information released to the market is valuable, is society better off if standard setters require that firms produce that information? Why or why not?
