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Instructors ManualChapter 5Copyright 2009 Pearson Education Canada 126

C!P"E# 5"he In$or%ation !pproach to &ecision 'se$ulness

5(1 )*er*ie+5(2 )utline o$ the #esearch Pro,le%5(2(1 #easons $or Mar-et #esponse5(2(2 .inding the Mar-et #esponse5(2(/ eparating Mar-etide and .ir%peci$ic .actors5(2(3 Co%paring #eturns and Inco%e5(/ "he 4all and 4ro+n tudy5(/(1 Methodology and .indings5(/(2 Causation ersus !ssociation5(/(/ )utco%es o$ the 44 tudy5(3 Earnings #esponse Coe$$icients5(3(1 #easons $or &i$$erential Mar-et #esponse5(3(2 I%plications o$ E#C #esearch5(3(/ Measuring In*estors Earnings Epectations5(3(3 u%%ary5(5 'nusual7 8onrecurring and Etraordinary Ite%s

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5(; "he In$or%ation Content o$ )ther.inancial tate%ent In$or%ation5(< Conclusions on the In$or%ation !pproach=E!#8I8>

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pecti*e on &ecision 'se$ulness o$.inancial #eportingI ,egin co*erage o$ this chapter ,y pointing out that +e are no+ starting to

applydecision theory and e$$icient securities %ar-ets theory to ,etter understand the role o$$inancial reporting to in*estors("he $irst step is to de*elop the concept o$the in$or%ation perspecti*e( I ,rie$ly re*ie+the 4ill Cautious decision theory ea%ple /(1 and e%phasi@e thatit is 4ill Cautious7 not

the accountant7 +ho has the pri%ary responsi,ility7 and %oti*ation7 to predict $uture $ir%per$or%ance( "he role o$ the accountant is tosupply use$ul in$or%ation in this regard7and not necessarily to %a-e direct predictions a,out current and $uture $ir% *alue( "othe etent that it $acilitatesin*estor predictions o$ $uture $ir% per$or%ance7 historical

cost,ased in$or%ation can ,e use$ul e*en though it does not directlyre*eal *alues("his is the essence o$ the in$or%ation perspecti*e(I o$ten play de*ils ad*ocate: at this pointand suggest to the class that the in$or%ationperspecti*e i%plies that the accountantAauditor is o$$thehoo-: should a $ir% $ail +ithouta +arning $ro% the historical cost,ased $inancial state%ents( I suggest that i$ the role o$

the $inancial state%ents does not include adirect prediction o$ $ir% *alue7 theaccountantAauditor is not responsi,le i$ it turns out that7 in retrospect7the $inancialstate%ents proper did not $oresee $inancialdistress( I try to steer the resulting

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discussion to a conclusion that +hile accountantsAauditors %ay li-e this argu%ent7 it isnot clear that in*estors7 regulators7 and the courts +ill accept

it( I also point out thataccountants are in co%petition +ith other in$or%ation sources7 pursuant to 4ea*ers19;/ paper re*ie+ed in ection 3(/( #epeated co%plaints ,y in*estors that $inancialdistress +as not predicted can only erode the accountants co%petiti*e position( ith a*ie+ to the %easure%ent perspecti*e to ,e introduced in Chapter 67 I as- i$ accountants

Instructors ManualChapter 5Copyright 2009 Pearson Education Canada 12

!!P( tandard setters could si%ply reBuireaccounting policies that are %ost highly associated +ith share returns(I so%eti%es put this suggestion to the classin the $or% o$ a Buestion( hile getting a

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good discussion going tends to ,e li-e pulling teeth7 so%e students+ill see theessential circularity( Instead o$ using accounting in$or%ation to in$or% the %ar-et7 the

suggestion in*ol*es using the %ar-et response to esta,lish the accounting policy( "osee the pro,le% +ith this approach7 consider an etre%e caseJ hy not %easure the$ir%s net inco%e as the change in its %ar-et *alue o*er the period"his %ay ,e agood %easure o$ the $ir%s econo%ic inco%e7,ut it contri,utes nothing to +hat the%ar-et already -no+s( i%ilarly7 adopting

accounting policies that ha*e the greatest%ar-et response does not in$or% the %ar-et( "he role o$ accounting in$or%ation is toepand and i%pro*e the stoc- o$ in$or%ation a*aila,le to the %ar-et7 not to re$lect it(Instructors ManualChapter 5Copyright 2009 Pearson Education Canada 1/1

!nother reply to the suggestion to use theassociation ,et+een accounting in$or%ation

and share returns as the ,asis $or accounting policy choice is to pointout that thepri*ate and pu,lic *alues o$ accounting in$or%ation are not the sa%e7leading to thedistinction ,et+een pri*ate and pu,lic goods gi*en in ection 5(6( "he distinction,et+een pu,lic and pri*ate goods is at the heart o$ the >onedes and &opuch D19;3paper re$erenced in ection 5(6( "hey s

ho+ that since accounting in$or%ation hascharacteristics o$ a pu,lic good7 reliance on %ar-et prices to %oti*ate $ir%s in$or%ationproduction decisions does not result in the socially ,est: a%ount o$ pri*ate in$or%ationproduction( .or ea%ple7 i$ a $ir% enGoys a st

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ronger share price response to the >8 innet inco%e +hen it use straight line a%orti@ation than +hen it uses declining ,alance7then the $ir% %ay pre$er straight line a%orti@ati

on Duse o$ straight line a%orti@ation is anin$or%ation production decision( hile thisis $ine $ro% the $ir%s perspecti*e7 +ecannot conclude $ro% this that straight line a%orti@ation is ,etter $ro% societysperspecti*e( "he reason7 as eplained in the tet7 is that the %ar-et does not ,ear allthe costs o$ producing the in$or%ation(ConseBuently7 society cannot use the share

price response as a signal o$ +hat in$or%ation $ir%s should produce7as it could $or apri*ate good( I$ the share price response does notincorporate all the costs7 +e cannotuse the correlation ,et+een straight line netinco%e and share price as an indicator o$the socially ,est a%orti@ation policy(tudents so%eti%es argue that i$ e%pirical securities %ar-ets research cannot lead to

accounting policy reco%%endations7 +hat is thepoint o$ studying it( "he response that ithelps us to ,etterunderstandho+ in*estors use $inancial accounting in$or%ation7 +hile*alid7 does not see% to settle the issue( I usually $all ,ac- on theargu%ent %ade inection 5(6 that7 despite di$$erences ,et+een the pri*ate and social *alues o$

accounting in$or%ation7 the greater the %ar-et response to accounting in$or%ation the%ore use$ul it %ust ,e to in*estors De*en though not necessarily to society7 hence thegreater the accountantKs co%petiti*e ad*antage( !lso7 anot

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her cost o$ accountingin$or%ation is that %anagers %ay not li-e toreport it Drecall %anage%ents scepticis%a,out ##!( ConseBuently7 the socially ,est a

ccounting policy %ust ta-e %anage%entsconcerns into account( "his issue is pursued in later chapters(Instructors ManualChapter 5Copyright 2009 Pearson Education Canada 1/2

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1( "he in$or%ation perspecti*e *ie+s $inancial reporting as a %eans tocon*eyuse$ul in$or%ation to in*estors( In*estors %ust then decide +hether to use thisin$or%ation in $or%ing their o+n posteriorpro,a,ilities o$ $uture pro$ita,ility andshare returns(

"he in$or%ation perspecti*e is consistent+ith the historical cost ,asis o$accounting7 ,ut does not rely on it(It appears7 on the ,asis o$ ,oth theory ande%pirical e*idence7 that $inancial state%ents7 traditionally containing a largehistorical cost,ased co%ponent7 pro*ide use$ul in$or%ation to in*estors(o+e*er7 there is no particular reason +h

y the in$or%ation %ust ,e historicalcost,ased( ##! in$or%ation is not historical cost,ased7 nor is %uch o$ thein$or%ation in notes and M&!( "he essenceo$ the in$or%ation approach is that7as %entioned a,o*e7 in*estors are assu%

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ed to use accounting in$or%ation7 andany other rele*ant in$or%ation as +ell7 in $or%ingtheir o+nassess%ents o$ $uture

per$or%ance the accountant does not doit $or the%( "he particular $or% o$disclosure does not %atter7 only the $actthat the in$or%ation is disclosed( "hus7the in$or%ation perspecti*e can ,e used to Gusti$y historical cost as the ,asis o$the $inancial state%ents proper7 +hilesupple%enting the state%ents +ithadditional in$or%ation( E$$icient %ar-ets

theory is then relied on to ensure thatin*estors7 on a*erage7 properly interpret this in$or%ation(2( )ne $actor that could ad*ersely a$$ect the accuracy o$ the esti%ate o$ a,nor%al returnsis the esti%ate o$ ,eta7 particularly i$ the $ir%s ,eta changes o*er ti%e( I$ the slope o$the regression line in .igure 5(2 is not correct7 or i$ ,eta has changed su,seBuent tothe period o*er +hich it +as esti%ated7 this +ill a$$ect the a,nor%al

returns esti%ate(!nother pro,le% is the identi$ication o$ the date the %ar-et $irst ,eca%e a+are o$ theearnings ne+s( 'sually7 this is ta-enas the date the announce%ent appeared in the$inancial press( o+e*er7 i$ thisdate is not accurate7 then the +rong #Mt

is used to

esta,lish the epected stoc- return( "his +ould thro+ o$$ the calculation o$ a,nor%alreturn(Instructors ManualChapter 5Copyright 2009 Pearson Education Canada 1//

"here %ay ,e other in$or%ation a$$ectingthe $ir%s share price on the day o$ its

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earnings announce%ent( .or ea%ple7 the $ir% %ay ha*e alsoannounced a change inits di*idend( 'nless such $ir%s are ecluded$ro% the sa%ple7 any a,nor%al return +ill

,e ascri,ed to the >8 or 48 in earningsrather than the other in$or%ation(

! %ore $unda%ental pro,le% is that in*estors %ay not necessarily %a-e in*est%entdecisions the +ay that the theory de*eloped in ection /(/ suggests( In*est%entdecisions %ay not ,e $ully or e*en partially di*ersi$ied7 in +hich case,eta is not theonly rele*ant ris- %easure( )r7 in*estor

s %ay ha*e so%e other %ethod o$ %a-ingin*est%ent decisions7 In +hich case the %ar-et %odel and C!PM %ay not pro*idegood esti%ates o$ epected and a,nor%al return( Do+e*er7 since e%pirical researchhas sho+n that a,nor%al returns as calculated in.igure 5(2 do relate to >8 or 48 inearnings7 it see%s that the in*est%enttheory underlying this $igure reasona,ly

predicts the decision processes o$the a*erage rational in*estor(Het another $actor is the signi$icance o$ industry e$$ects7 in addition to %ar-et+ide and$ir%speci$ic co%ponents o$ return( .or ea%ple7 $ir% G %ay ,e in an industry that isepected to ,ene$it greatly $ro% a reductiono$ trade ,arriers( I$ this reduction +asannounced around the date that $ir% G announced

its current earnings7 the a,nor%alreturn around the date o$ earnings release could ,e attri,uted to this industry e$$ectrather than to earnings(/( "here are t+o eplanations $or this pheno%enon7 either o$ +hich produces the steadily

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rising D$or >8 $ir%s and steadily $alling D$or48 $ir%s pattern o$ cu%ulati*e sharereturns sho+n in .igure 5(/()ne eplanation is that the $ir%s earnings

causethe %ar-et reaction( In*estors thenha*e incenti*es to $igure out earnings early( "hey can do this in a*ariety o$ +ays7 $orea%ple $ro% Buarterly reports7 analystand %anager $orecasts7 analyses o$persistence in pre*ious inco%e state%ents7 and sales and production in$or%ation( !sthe year progresses7 in*estor

s o,tain increasingly accurate esti%ates o$ the yearsearnings relati*e to the earnings o$ $ir%sin general7 and the a,nor%al returns o$ the>8 or 48 $ir% then increase or decrease e*enly o*er the year(

! second eplanation is that share price and earnings are ,oth associated Di(e(7correlated +ith the underlying real state o$ the $ir%( I$ the $ir% in an econo%ic sense is