Chapter 8: Usefulness of Accounting Information to Investors and Creditors

Firm valuation models

Efficient-markets hypothesis

CAPM

Cross-sectional valuation studies

Company-auditor roles

Accounting data and creditors

Accounting allocations

Information economics

Financial Accounting Standards Board

Primary user groupsInvestors

Creditors

Cost-Benefit calculusCost considerations confined to producers

Benefits for investors and creditors

Firm Valuation Models

Dividend valuation model: value of a firm is the present value of future expected dividends to be received by stockholders

Cash flow valuation model: value of firm is the present value of future net cash flows

Theoretical literature implications are that accrual accounting systems incorporate the attribute that determines firm valuation...net cash flow data.

Efficient-Markets Hypothesis

Information content: when an item of information causes a price response in the security

Three formsWeak

Semistrong

Strong

Foundation of Capital Market ResearchPortfolio Theory

Risk can be reduced by holding a portfolio of investments

Risk typesUnsystematic (diversifiable)

Systematic (undiversifiable)

Capital Asset pricing Model (CAPM)

Theoretical pricing of stocks

Market assumed to be a diversified portfolio

Correlation made between returns on individual stocks and market returns

Regression analysis fits a line to the scattergraph

Slope of the characteristic line is beta

Security Returns vs. Market Returns

Return on Stock

Return on Market

Characteristic Line

+

-

Rj = expected return on security j

i = risk-free rate of return

Rm = expected return on the market portfolio

Bj = beta coefficient for security j

Rj = i + Bj (Rm – i)

Empirical studies in accounting use a simpler approach called the market model

Rj = α j + Bj (Rm) + ej

αj = the intercept from the regression

ej = random error term

Unexpected or Abnormal Returns

Captured in the error term ej

A common research approach is to regress these abnormal returns on accounting variables such as unexpected reported earnings for the same time period to determine if there is information content

Ball and Brown (1968)

Information content of accounting numbers

Seminal study showed the direction of change in reported earnings was positively correlated with security price movements

Not surprising...expect accounting income to be part of the information used by investors in assessing risk and return

Capital Market Research

Accounting earnings appear to have information content and to affect security prices

Alternative accounting policies with no apparent cash flow consequences have no information content

Alternative accounting policies with cash flow consequences do have information content

Capital Market Research

Incentives exist to choose certain accounting policies where choice exists, owing to indirect cash consequences

Accounting-based risk measures correlate with market risk measures, suggesting that accounting numbers are useful for risk assessment

Another research approach

Examine the association between accounting data reported in the financial statements and the levels of stock prices (not the abnormal returns)

Referred to as cross-sectional valuation

Company-Auditor Roles

Key assumption of accounting research is that financial statement information is reliable...GAAP applied on consistent basis

Jointly produced by company and auditorDemand can be explained by agency theory

Auditor researchQualified audit report leads to lower stock priceBig Six audits more highly valued

Accounting Data and Creditors

Predicting corporate bankruptcy (loan default)

Bond ratings

Interest-rate risk premiums on debt

Experimental studies of the role of accounting data in lending decisions

Usefulness of Accounting Allocations

Revenue recognition and the matching of costs to revenues over multiple accounting periods requires use of allocations

Criticized as arbitrary, no allocation is completely defensible against other methods

No evidence to support the contention that allocation-based financial statements are useless

Accounting Information Evaluation

Information economics, decision theoryDoes not provide answers to normative questionsCan determine only the value of specific information for a narrowly defined decision

LimitationsReal world decision makers face more complex decisionsUser diversity is an issue; behaviors may vary

Chapter 8: Usefulness of Accounting Information to Investors and Creditors

Firm valuation models

Efficient-markets hypothesis

CAPM

Cross-sectional valuation studies

Company-auditor roles

Accounting data and creditors

Accounting allocations

Information economics