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Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Deegan, Financial Accounting Theory 3e
Financial Accounting Theory
Craig Deegan
Chapter 10
Reactions of capital markets to financial
reporting
Slides written by Craig Deegan

10-2
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Learning objectives
In this chapter you will be introduced to:
the role of capital market research (CMR) in assessing
the information content of accounting disclosures
the assumptions of market efficiency typically adopted in
capital market research
the difference between capital market research that looks
at the information content of accounting disclosures, and
capital market research that uses share price data as a
benchmark for evaluating accounting disclosures
why unexpected accounting earnings and abnormal
share price returns are expected to be related
the major results of capital market research into financial
accounting and disclosure
10-3
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Capital market research
introduction
Explores the role of accounting and other financial
information in equity markets

Involves examining statistical relations between
financial information and share prices

Reactions of investors evident from capital market
transactions

No share price change implies no reaction to
particular information
10-4
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Capital market versus behavioural
research
Capital market research (the topic of this lecture)
assesses the aggregate effect of financial reporting on
investors
considers only investors

Behavioural research (the topic of the next lecture)
analyses individual responses to financial reporting
examines decision-making by many groups
e.g. bank managers, loan officers, auditors
10-5
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Reasons for capital market research
Information about earnings and its components is
the primary purpose of financial reporting

Earnings are oriented toward the interests of
shareholders

Earnings is the number most analysed and
forecast by security analysts

Reliable data on earnings is readily available
10-6
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Underlying assumption of CMR
EMH
CMR relies on the assumption that equity markets
are efficient
in accordance with Efficient Market Hypothesis (EMH)

Efficient market defined as a market that adjusts
rapidly to fully impound information into share
prices when the information is released
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Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Three forms of market efficiency
Weak form: prices reflect information about past
prices and trading volumes

Semi-strong form: all publicly available information
is rapidly and fully impounded into share prices in
an unbiased manner when released
most relevant for accounting-based capital market
research

Strong form: security prices reflect all information
(public and private)
10-8
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Market efficiencyimplications for
accounting
If markets are efficient they will use information
from various sources when predicting future
earnings
If accounting information does not impact on share
prices then it is deemed not to have any
information value above that currently available
10-9
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Market efficiency share prices react
to information from various sources
For example, material provided within the textbook
indicates that share prices have been found to
react not only to earnings data but also to such
things as:
News about senior executive resignations
Takeover rumours posted to internet discussion sites
Which raises possible issues about the regulation of
information provided on such sites
Concerns raised by auditors, particularly in relation to
going concern considerations (unless anticipated by the
market)
Industry-wide changes, such as the implications
associated with the introduction of particular legislations
(such as the Sarbanes-Oxley Act in the US)
10-10
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Share prices react to information
from various sources (cont.)
Again, a share price reaction indicates that the
news has information content

Conversely, no share price reaction indicates that
the news or event did not act to cause the market
to revise any previous expectations held about a
firms future cash flows

10-11
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Earnings/return relation
Share prices are the sum of expected future cash
flows from dividends, discounted to their present
value using a rate of return commensurate with the
companys risk

Dividends are a function of accounting earnings

Unexpected earnings rather than total earnings
expected to be associated with a change in share
price
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Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Earnings/return relationmarket
model
Used to separate out firm-specific share price
movements from market-wide movements
derived from the Capital Asset Pricing Model

Assumes investors are risk averse and have
homogeneous expectations

Its use allows the researcher to focus on share
price movements due to firm-specific news
10-13
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Earnings/return relationmarket
model (cont.)
Total or actual returns can be divided into
normal (expected) returns given market-wide movements
abnormal (unexpected) returns due to firm-specific share
price movements

Abnormal returns used as an indicator of
information content of announcements
10-14
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRBall and Brown
(1968) study
Examined data from 261 US firms
Tested whether firms with unexpected increases in
accounting earnings had positive abnormal
returns, and firms with unexpected decreases had
negative abnormal returns
Found that
information contained in the annual report, prepared
using historical cost was useful to investors
85 to 90% of earnings announcement is anticipated by
investors
much of information is obtained from other sources
10-15
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRextent of alternative
information sources
Information content varies between countries and
companies

Compared to US markets, Australian market had
slower adjustments during the year with larger
adjustments at earnings announcement
less alternative sources of information for Australian
market

Less alternative sources of information for smaller
firms than larger firms
10-16
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRpermanent and
temporary changes
Research examined relationship between the
magnitude of unexpected changes in earnings
(EPS) and magnitude of abnormal returns
known as the earnings response coefficient
Some research has shown that a 1% unexpected change
in earnings associated with 0.1 to 0.15% abnormal return
depends on whether earnings increases expected to be
permanent or temporary
10-17
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRrelative magnitudes
of cash and accruals
Earnings persistence depends on proportion of
accruals relative to cash flows
firms with large accruals relative to actual cash flows
unlikely to have persistently high earnings

Share prices found to act as if investors fixate on
reported earnings without considering relative
magnitudes of cash and accrual components
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Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRinformation
announcements of other firms
Earnings announcements by one firm also results
in abnormal returns to other firms in the same
industry
Related to whether the news reflects a change in
conditions for the entire industry, or changes in
relative market share within the industry
For example, if an organisation within an industry
is the first to prepare its financial results for the
year, and it reports record profits that were
unexpected by the market, then this would often
cause share price increases across the industry
For example, Accounting Headline 10.6 shows that when
CBA reported record profits this was followed by share
price increases in other banks even prior to their earnings
announcements
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Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRinformation content
of earnings forecasts
Announcements of expected earnings rather than
actual earnings are associated with share returns

Management and security analysts both make
forecasts
10-20
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRbenefits of
voluntary disclosure
Voluntary disclosures include those in annual
reports as well as media releases etc.

Firms with more disclosure policies have
larger analyst following and more accurate analyst
earnings forecasts
increased investor following
reduced information asymmetry
reduced costs of equity capital
10-21
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRrecognition versus
footnote disclosure
Recognising an item in the financial statements is
perceived differently to disclosure in footnotes

Investors place greater reliance on recognised
amounts than on disclosed amounts
10-22
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRsize
Relationship between earnings announcements
and share price movements is inversely related to
the size of the entity

Earnings announcements found to have a greater
impact on share prices of smaller firms than larger
firms

More information generally available for larger
firms
10-23
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRunexpected changes in
earnings vs. unexpected changes in expenses
If earnings surprises are accompanied by
revenue surprises of similar magnitude in the
same direction, then the earnings surprises are
driven by revenue growth rather than by a
reduction in expenses.
Researchers expect earnings growth driven by
revenue growth to exhibit a different level of
persistence compared with earnings growth driven
by expense reduction.
Jegadeesh and Livnat's (2006) results indicate that
the market does tend to react more to unexpected
earnings when these 'surprises' are due to
increases in revenues.
10-24
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Do current prices anticipate future
announcements?
As firm size increases, share prices incorporate
information from wider number of sources
relatively less unexpected information when earnings are
announced

May be able to argue that share prices anticipate
future earnings announcements for larger firms
with some accuracy
10-25
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Accounting earnings reflecting
information
Rather than determining whether earnings
announcements provide information, recent
research examines whether earnings
announcements reflect information that has been
already used by investors
looking back the other way
market prices viewed as leading accounting earnings
10-26
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Accounting earnings reflecting
information (cont.)
Share prices are considered as benchmark
measures of firm value

Share returns are considered as benchmark
measures of firm performance

Benchmarks are then used to compare usefulness
of alternative accounting and disclosure methods

Based on premise that market values and book
values are both measures of firm value
10-27
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Accounting earnings reflecting
information (cont.)
If market value is related to book value, returns
should be related to accounting earnings per
share, divided by price at the beginning of the
accounting period
provides an underlying reason why we should expect
returns to be related to earnings over time
10-28
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRaccounting
earnings reflecting information
Beaver, Lambert and Morse (1980) found share
prices and related returns were related to
accounting earnings

Because of various information sources, price
appeared to anticipate future accounting earnings

Supported by Beaver, Lambert and Ryan (1987)
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Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMRaccounting earnings
reflecting information (cont.)
Dechow (1994) found over short intervals earnings
are more strongly associated with returns than are
realised cash flows
the ability of cash flows to measure firm performance
increases as the measurement interval increases
10-30
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Results of CMR accounting earnings
reflecting information (cont.)
Studies examining which asset value approaches
provide accounting figures that best reflect market
valuation found:
fair value estimates of banks financial instruments seem
to provide a better explanation of bank share prices than
historical cost (Barth, Beaver & Landsman 1996)
revaluation of assets results in better alignment of market
and book values (Easton, Eddy & Harris 1993)
10-31
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Deegan, Financial Accounting Theory 3e
Relaxing assumptions about market
efficiency
Recent years have seen a number of researchers
questioning some assumptions about market
efficiency
Market reactions to information often found to be
longer than would be anticipated from an efficient
market. Also market found to sometimes under-
react to particular announcements
Created new areas for researchfor example
what factors influence earnings drift
So, should we reject research that has embraced
the EMH?