Scott 8e ism ch5 - Textbook answers PDF

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Sc o t t , Fi n a nc i a lAc c o un t i n gTh e o r y ,8 t hEd i t i on I n s t r u c t o r ’ sSo l u t i on sMa n ua l Ch a p t e r1

CHAPTER 5 THE VALUE RELEVANCE OF ACCOUNTING INFORMATION 5.1

Overview

5.2

Outline of the Research Problem 5.2.1 Reasons for Market Response 5.2.2 Finding the Market Response 5.2.3 Separating Market-Wide and Firm-Specific Factors 5.2.4 Comparing Returns and Income

5.3

The Ball and Brown Study 5.3.1 Methodology and Findings 5.3.2 Causation Versus Association 5.3.3 Outcomes of the BB Study

5.4

Earnings Response Coefficients 5.4.1 Reasons for Differential Market Response 5.4.2 Implications of ERC Research 5.4.3 Measuring Investors’ Earnings Expectations 5.4.4 Summary

5.5

A Caveat about the “Best” Accounting Policy

5.6

The Value Relevance of Other Financial Statement Information

5.7

Conclusions on Value Relevance

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Sc o t t ,Fi n a nc i a lAc c o un t i n gTh e o r y ,8 t hEd i t i on I n s t r u c t o r ’ sSo l u t i on sMa n ua l Ch a p t e r1

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

To Appreciate the Value Relevance Approach to the Decision Usefulness of Financial Reporting

I begin coverage of this chapter by pointing out that we are now starting to apply decision theory and efficient securities markets theory to better understand the role of financial reporting to investors. The first step is to develop the concept of value relevance, as empirical testing of the predictions of decision theory and market efficiency. I briefly review the Bill Cautious decision theory Example 3.1 and emphasize that it is Bill Cautious, not the accountant, who has the primary responsibility, and motivation, to predict future firm performance. The role of the accountant is to supply useful information in this regard, and not necessarily to make direct predictions about current and future firm value. To the extent that it facilitates investor predictions of future firm performance, historical cost-based information can be useful even though it does not directly reveal values. I often play “devil’s advocate” at this point and suggest to the class that since decision usefulness implies it is not the role of the accountant/auditor to predict future firm performance and value, is the accountant/auditor responsible if it turns out that the financial statements did not foresee financial distress. I try to steer the resulting discussion to a conclusion that while accountants/auditors may like this argument, it is not clear that investors, regulators, and the courts will accept it. I also point out that accountants are in competition with other information sources, pursuant to Beaver’s 1973 paper reviewed in Section 4.3. Repeated complaints by investors that financial distress was not predicted can only erode the accountant’s competitive position. If time, with a view to the measurement approach to be introduced in Chapter 6, I ask if accountants could improve their competitive position by assuming greater responsibility for reporting on current values.

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Sc o t t ,Fi n a nc i a lAc c o un t i n gTh e o r y ,8 t hEd i t i on I n s t r u c t o r ’ sSo l u t i on sMa n ua l Ch a p t e r1

2.

To Introduce Empirical Securities Markets-Based Accounting Research

The body of research in this area is vast. I concentrate in this chapter on providing a framework within which the research can be interpreted, rather than trying to cover very much of it per se. To establish this framework, I begin by pointing out that the empirical research addresses some very fundamental and interesting questions — do investors use the accountant’s product? If they don’t, of what value is financial reporting? I then argue that the framework is provided by the decision theory model, again referring back to Example 3.1 — if investors find financial accounting useful, then we should see trading volume and securities prices responding in predictable ways to accounting information. Having said this, I then point out that actually finding a securities market response is not easy. I discuss at an intuitive level the various research problems outlined in Section 5.2. I end up this discussion by emphasizing that the basic procedure to find a market response is to associate some measure of market return on securities with some measure of the information content of the financial statements. I then review the 1968 Ball and Brown study. Since their methodology takes some getting used to for students who have not seen it before, I stick fairly closely to the coverage in Section 5.3, although the article itself could usefully be assigned as reading by instructors who wish to consider BB’s procedures in greater depth. I concentrate on explaining how BB operationalized the measurements of market return and information content of net income. Figure 5.3 is useful in this regard. The figure also ties nicely back to the efficient securities market theory of Chapter 4, and the discussion in Example 3.2 of the dichotomization of factors affecting share price into market-wide and firm-specific factors. I go on to review the ERC research outlined in Section 5.4, as an example of an important direction in which the Ball and Brown methodology developed. I bring out how the ERC 3 Co p yr i gh t©2 02 0Pe a r s o nCa n a daI n c .

Sc o t t ,Fi n a nc i a lAc c o un t i n gTh e o r y ,8 t hEd i t i on I n s t r u c t o r ’ sSo l u t i on sMa n ua l Ch a p t e r1

is a measure of earnings quality, and discuss the various measures of earnings quality. Earnings persistence, in particular, is an important component of earnings quality. Persistence ties in nicely with full disclosure, since poor disclosure can be used to hide low-persistence items. Discussion of one of the chapter problems can be helpful to get across how poor disclosure can lower earnings quality by hiding low-persistence earnings —see problems 16, 18, 20. Persistence appears later as an important component of Ohlson’s clean surplus theory (Section 6.9.2—optional reading). An interesting exercise is to attempt to estimate the persistent portion of the earnings of a large and complex company from the information in its annual report. Indeed, this could be a useful student assignment, although one that is hard to mark. I tried such an assignment once, but the student answers tended to be fairly superficial. In part, the problem is that earnings persistence is hard to determine precisely. Perhaps, as mentioned above, an in-class case discussion of an actual annual report is a better way to apply the persistence concept. You may have noticed that most of the research outlined in this chapter is now quite old. This is not because this research is no longer relevant to a study of accounting theory, but rather that accounting research has moved on to other topics. I have, however, outlined two more recent studies. Jones and Smith (2011) can be used to introduce the concept of special items and some differences between IASB and FASB practice. McVay’s study of classification shifting provides an interesting example of financial statement manipulation of earnings persistence. Instructors have considerable flexibility to augment the coverage of this chapter, depending on their own interests and backgrounds. I have tried to design the chapter to facilitate this. As mentioned, I provide a decision-theoretic framework within which the empirical research can be interpreted. Also, I provide extensive references to articles upon which the chapter material is based. I have, as well, introduced topics that could usefully be developed further. These include the notions of narrow and wide windows, which lead to the distinction between causation and association in Section 5.3.2, and measuring investors’ earnings expectations in Section 5.4.3. 4 Co p yr i gh t©2 02 0Pe a r s o nCa n a daI n c .

Sc o t t ,Fi n a nc i a lAc c o un t i n gTh e o r y ,8 t hEd i t i on I n s t r u c t o r ’ sSo l u t i on sMa n ua l Ch a p t e r1

Section 5.4.3 also contains a brief discussion of analysts’ forecasts as a measure of these expectations. This textbook does not give much attention to the considerable research into analyst forecasts, other than to explain such forecasts are a way to estimate expected earnings. However, the coverage here provides an occasion for instructors who wish to dig beeper into issues of forecast accuracy and bias to do so. In particular, the Easton and Sommers 2007 study, and the additional reference in Note 24 may be of interest. For instructors who wish to cover securities market response to non-earnings information (hard to find), Section 5.6 considers the study of Lev and Thiagarajan (1993) which suggests that the relationship between balance sheet information and share price shows up via the ERC, rather than directly. Their paper is also useful as a way of bringing out the concept of earnings quality. The paper is quite readable and could be assigned as supplementary reading if desired. More recently, Defranco et al (2011) studied the information content of Note information. This study is more indicative of current capital market research, which often considers the presence of more than one type of rational informed investor. In this edition, I have emphasized some of the limitations of the theory in understanding how information affects capital markets—see the discussion of the assumptions underlying the CAPM in Section 4.5.2 and the outlines of some models that drop these assumptions in Section 6.5 (optional sections). 3.

To Appreciate the Limitations of Empirical Securities Markets Research for Accounting Policy Recommendations

Given that empirical research has established an association between accounting information and the market returns on firms’ shares, it may seem reasonable to suggest that the best accounting policy is the one that produces the highest association. That is, if net income calculated using, say, straight-line amortization is more highly associated with changes in the market value of (i.e., the return on) the firm’s shares than is net income calculated using declining balance amortization, then investors find straight-line amortization policy more useful, since it is more consistent with an (efficient) securities market’s evaluation of the firm. Such reasoning may have the potential to identify the 5 Co p yr i gh t©2 02 0Pe a r s o nCa n a daI n c .

Sc o t t ,Fi n a nc i a lAc c o un t i n gTh e o r y ,8 t hEd i t i on I n s t r u c t o r ’ sSo l u t i on sMa n ua l Ch a p t e r1

most useful accounting policies from the great variety of policies available under GAAP. If so, could standard setters simply require accounting policies that are most highly associated with changes in the market value of the firm’s shares? I sometimes put this question to the class. While getting a good discussion going tends to be like pulling teeth, some students will see the essential circularity. Adopting accounting policies that have the greatest market response does not inform the market. To clinch this point, ask if the best way to measure a firm’s net income is to drop reporting of net income and, instead, simply report the change in the market value of the firm for the period (adjusted for capital transactions). Assuming reasonably efficient security markets, this would be an economically correct measure of income. However, the answer is no, since nothing is added to what the market already knows. The role of accounting information is to expand and improve the stock of information available to the market, not to reflect it. Another reply to the suggestion to use the association between accounting information and share returns as the basis for accounting policy choice is to point out that the private and public values of accounting information are not the same, leading to the distinction between private and public goods given in Section 5.5. The distinction between public and private goods is at the heart of the Gonedes and Dopuch (1974) paper referenced in Section 5.5. They show that since accounting information has characteristics of a public good, reliance on market prices to motivate firms’ information production decisions does not result in the socially “best” amount of private information production. For example, if a firm enjoys a stronger share price response to the GN in net income when it uses straight line amortization than when it uses declining balance, then the firm may prefer straight line amortization (use of straight line amortization is an information production decision). While this is fine from the firm’s perspective, we cannot conclude from this that straight line amortization is better from society’s perspective. The reason, as explained in the text, is that the market does not bear all the costs of producing the information. Consequently, society cannot use the share price response as a signal of what information firms should produce, as it could for a private good. If the share price

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response does not incorporate all the costs, we cannot use the correlation between straight line net income and share price as an indicator of the socially best amortization policy. Students sometimes ask that if empirical securities markets research cannot lead to accounting policy recommendations, what is the point of studying it? The response that it helps us to better understand how investors use financial accounting information, while valid, does not seem to settle the issue. I usually fall back on the argument made in Section 5.5 that, despite differences between the private and social values of accounting information, the greater the market response to accounting information the more useful it must be to investors (even though not necessarily to society), hence the greater the accountant's competitive advantage. Also, another cost of accounting information is that managers may not like to report it (recall management’s scepticism about RRA). Consequently, the socially best accounting policy must take managements’ concerns into account. This issue is pursued in later chapters.

SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

If share price, returns, or volume respond to accounting information, that information is said to be value relevant. That is, investors find the information to be decision useful. Greater security market response implies greater decision usefulness, but does not necessarily imply that the accounting policy that creates the greatest market response is socially best. Value relevance is consistent with the historical cost basis of accounting, but does not rely on it. It appears, on the basis of both theory and empirical evidence, that financial statements, traditionally containing a large historical cost-based component, do provide useful information to investors. However, there is no particular reason why the information must be historical cost-based. RRA information is not historical cost-based, nor is much of the information in balance sheets and supplementary information, including financial

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statement notes and MD&A. These disclosures contain a large current value, forward-looking component. 2.

One factor that could adversely affect the accuracy of the estimate of abnormal returns is the estimate of beta, particularly if the firm’s beta changes over time. If the slope of the regression line in Figure 5.2 is not correct, or if beta has changed subsequent to the period over which it was estimated, this will affect the abnormal returns estimate. Another factor is the identification of the date the market first became aware of earnings news. Usually, this is taken as the date the earnings announcement appeared in the financial press or company announcement or conference call. However, if this date is not accurate, then the wrong RMt is used to establish the expected stock return. This would throw off the calculation of abnormal return. There may be other information affecting the firm’s share price on the day of its earnings announcement. For example, the firm may have also announced a change in its dividend. Unless such firms are excluded from the sample, some of any abnormal return could be ascribed to the GN or BN in earnings rather than to the other information. A more fundamental problem is that investors may not necessarily make investment decisions the way that the theory developed in Section 3.3 suggests. Investment decisions may not be fully or even partially diversified, in which case beta is not the only relevant risk measure. Or, investors may have some other method of making investment decisions, in which case the market model and CAPM may not provide good estimates of expected and abnormal return. (However, since empirical research has shown that abnormal returns as calculated in Figure 5.2 do relate to GN or BN in earnings, it seems that the investment theory underlying this figure reasonably predicts the decision processes of the average rational investor.) The CAPM makes a number of assumptions. For example, it does not take information asymmetry and resulting estimation risk into account. Consequently, investors may not react to earnings information exactly as the CAPM predicts. For example, they may be concerned about inside information and/or low-quality reporting including possible 8 Co p yr i gh t©2 02 0Pe a r s o nCa n a daI n c .

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manager manipulation of the financial statements (these possibilities are discussed in later chapters). If the model generating investor reaction differs from the CAPM, abnormal returns will be misstated, possibly leading to wrong conclusions. Yet another factor is the significance of industry effects, in addition to market-wide and firm-specific components of return. For example, Firm J may be in an industry that is expected to benefit greatly from a reduction of trade barriers. If this reduction was announced around the date that Firm J announced its current earnings, the abnormal return around the date of earnings release could be attributed to this industry effect rather than to earnings. 3.

This anticipation up to a year ahead is consistent with a correlation argument. If the firm in an economic sense is performing well, the efficient market learns of this from timelier sources and responds by bidding up its share price. That is, abnormal share return rises over the course of the year. Come year-end, the firm reports GN in its earnings since net income also captures (with a lag) at least some of the good economic performance. Thus, GN will be associated with increasing abnormal returns over the year, but does not cause the market reaction. A similar pattern occurs when firms are performing poorly. The market response in month 0 is most consistent with the causation argument. A welldesigned study will remove firms with other firm-specific factors affecting share return from the sample, such as dividend announcements and stock splits. Then, if the only other firm-specific effect on share return during the narrow window of one month is the release of earnings information, it can be argued that the accounting information caused the market reaction. Of course, a lot can happen in a month-long window, and it is possible that not all firms with other firm-specific factors affecting returns were eliminated. This dampens the causati...